US Weekly Economic Commentary: Storm clouds building

Economic and financial developments this week provided mixed signals on the state of the economy. On balance, these signals point towards an economy experiencing slowing growth, persistently high inflation, and building storms clouds that could spell trouble ahead.

The initial report of first-quarter GDP showed modest growth of 1.1% (annual rate), down from 2.9% averaged over the second half of last year. This was about a percentage point lower than our tracking estimate early in the week before revisions to retail sales suggested considerably less momentum in consumer spending than previously indicated.

Overall, the GDP report contained a mix of fairly strong growth of final sales and a sharp decline in the pace of inventory building that is more supportive of positive growth in the second quarter. As a result, we are now looking for GDP to rise slightly in the second quarter in contrast to our prior expectation of a small decline. Together, the revised outlook for first- and second-quarter growth is about 0.1 percentage point slower than we projected a month ago.

The expected softness in the second quarter leaves open the possibility that the US will slip into recession by midyear, and storm clouds continue to build. Persistently high inflation, as seen in the reports this week on personal consumption expenditures (PCE) in March and the employment cost index (ECI) for the three months ended March, is surely unnerving to Federal Reserve policymakers. The core PCE price index rose 0.3% from February to March and at a 4.9% annualized pace over the three months ending in March. The ECI for private industry workers rose 1.2% in the three months ended March and 4.8% over the past year. Unit labor costs in the nonfarm business sector appear on track to rise at an annualized pace above 5% in the first quarter, on the heels of a 6.3% rise last year.

This computes to a continuing margin squeeze that will add pressure to raise prices and trim costs. The implication is persistently high inflation and more layoffs ahead. It's the persistence of unacceptably high inflation that signals one or more additional rate hikes and a necessary easing of labor and product market tightness.

Commercial real estate

Additional storm clouds are building in the commercial real estate (CRE) sector. We caution against making too much of press reports, but the underlying story is not encouraging, especially in the office segment. Nevertheless, commercial banks and insurance companies are big providers of capital to this sector. Unexpected and sharp declines in CRE prices could supercharge a negative feedback loop through the banking sector where lenders pull back sharply as they see valuations drop, only to force more sales and further price declines.

We are anticipating a slowing in bank lending to act as a headwind to growth over the next few quarters. It remains to be seen just how severe that deceleration will be and what effect it will have in slowing growth. Encouragingly, in the week ended April 19, bank credit and deposits at commercial banks in the US expanded slightly, suggesting continued stability in these measures. This was the case for the group of the top 25 "large" banks and all other "small" banks.

On the bright side, home sales and sale prices reported for February were stronger than expected, providing further evidence that housing is putting in a bottom after a large decline over the past year as mortgage rates soared. Mortgage rates have declined from their recent peak and have hovered around 6.4% the past few weeks, lending support to sales and builder optimism.

Fed expectations

The Federal Open Market Committee (FOMC) will meet next week and announce their policy decisions on Wednesday, May 3. Given the persistence of inflation above their 2% objective as well as the apparent normalization of banking sector activity following the turmoil in March, the FOMC is primed to raise interest rates yet again. We expect them to do so by 25 basis points to a range of 5% to 5¼%. This would be the third consecutive hike of 25 basis points and would bring the cumulative increase in the target funds rate since March 2022 to 500 basis points (5 percentage points).

The outlook for what happens beyond the next meeting, however, is as uncertain as it has been in some time. While inflation remains above their target, there are some signs of easing. Additionally, there are lingering concerns that tumult in the banking sector may re-emerge. Great attention will be paid to whatever signal the FOMC provides regarding the course of future policy via the statement to be released Wednesday afternoon and in Chair Jerome Powell's press briefing shortly thereafter.

Our expectation is that the FOMC will pause rate increases following a hike in May, but there is a fairly high risk that the inflation picture will force another hike in June. Hawks will argue that there has not been sufficient tightening in financial conditions to get the job done, and they are correct, thus far. The same reasoning suggests that rate cuts are unlikely until next year.

This week's economic releases:

• Manufacturers' shipments, inventories and orders (May 2): We estimate inventories declined 0.8% in March, following a decrease of 0.1% in February.
• Light vehicle sales (May 2): We estimate light vehicle sales of 15.3 million units for April. This would leave sales in line with what has been a broadly firming trend since last spring.
• Nominal trade deficit (May 4): We estimate the nominal trade deficit narrowed in March by $7.5 billion to $62.5 billion.
• Nonfarm payroll employment (May 5): A gain in employment of about 183 thousand in April alongside an increase in the unemployment rate would likely be accompanied by an increase in the labor-force participation rate.
• Compensation per hour in the nonfarm business sector (May 4): We estimate compensation per hour rose at a 2.7% annual rate in the first quarter, and a decline in output per hour (productivity) of about 2.5%. This implies a 5.3% annualized increase in unit labor costs in the first quarter. Rapidly rising unit labor costs are contributing to upward pressure on inflation.

This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.