The startling reality of today’s GDP figures reveals a
U.S. economy in which weaker than expected growth is occurring against a backdrop
of accelerating inflation. Despite the positive spin, this is not the glowing
economic report that the consensus has been predicting. First quarter GDP grew
by 4.2%, verses expectations of 5%, virtually flat with the 4.1% growth rate
achieved in the prior quarter, and well below the 8.2% growth rate experienced
in third quarter of ’03.

However, upon closer review it is clear that the 4.2% figure consists largely
of soaring federal spending that overcame decelerating private sector growth.
For example, durable goods purchases declined by 4.7% verses a decline of only
.7% in the previous quarter. Business investment in non-residential structures
declined by 6.5% (the biggest decline since the third quarter of 2002), versus
a decline of only 1.4% in the previous quarter. Growth in both residential
and non-residential fixed investments also decelerated from up 7.9% and up
10.9% in the previous quarter to up only 2.1% and up 7.2% in the current quarter,
respectively. Likewise, spending on business equipment and software grew by
11.5%, but this compares to a 14.9% percent rate in the prior quarter. The
growth deceleration in international trade was even more spectacular, with
the real exports growth rate contracting from plus 20.5% last quarter to up
only 3.2% this quarter, and the growth rate of real imports contracting to
up 2% this quarter verses up 16.4% last quarter.

On the other hand, Federal spending increased by 10.1% verses an increase
of only.7% in the prior quarter, with defense spending growing at a rate of
15.1% versus 3% in the prior quarter. Even non-defense spending increased by
.7% verses a 3.7% decrease in the prior quarter. Were it not for this dramatic
increase in military spending, first quarter GDP growth would have certainly
been below 4%, resulting in back-to-back months of declining GDP growth.

In contrast, the overwhelming evidence of accelerating inflation continues
to mount. The GDP deflator rose to 2.5% in the current quarter verses 1.5%
in the prior quarter, and well ahead of the 2% that had been forecast. The
Personal consumption expenditure index (Greenspan’s professed favorite measure
of inflation) rose by 3.2%, the fastest in three years, while the core, less
food and energy, rose by 2%, the fastest since the forth quarter of 2000. United
labor costs rose by 1.1%, with benefit costs rising at their fastest pace in
twenty years.

These numbers clearly show that the rate of growth in the U.S. economy is
already slowing, despite the fact that the Fed has yet to raise interest rates
by even a single basis point. Imagine what will happen to growth when rates
actually rise! These figures also reflect the added spending which resulted
from the last of the tax refunds and the final wave of mortgage refinancing.
None of this added stimulus will be present in future quarters.

In fact, the details of this GDP report are so troubling that it would seem
to push any Fed rate hike father into the future, were it not for the compelling
evidence of accelerating inflation. Treasury prices initially rallied in response
to the weaker than expected GDP data, but ultimately fell in response to the
higher inflation data, further supporting my long held view that when the Fed
finally does raise interest rates it will be in response to higher inflation,
not accelerating growth. In fact, Fed rate hikes will continue even as the
U.S. economy slips back into recession, as inflation becomes increasingly more
pronounced. Today’s report further supports my prediction of a return to stagflation,
and flies in the face of the rosy scenarios being touted by Wall Street and
the Fed.