Will Inflation Recede With Slower Economy?

Growth of the U.S.economy was less than half that of the first quarter, according to the Commerce Department in its first estimate of second-quarter Gross Domestic Product.  GDP increased at a seasonally adjusted 2.5% annual rate April, compared to 5.6% in the first quarter and also well below economists’ estimates of 3.2%. 

Worse, the Fed’s closely watched price index for personal consumption expenditures climbed 4.1%, after rising 2.0% in the first quarter.  The PCE price gauge excluding food and energy rose 2.9% after going 2.1% higher January through March, according to the Wall Street Journal.

The consumer is pulling in his horns.  Consumer spending which represents about 70% of GDP rose 2.5% after soaring 4.8% in the first quarter. Consumers contributed 1.74 percentage points to GDP in the second quarter after adding 3.38 percentage points in the first quarter.  Purchases of durable goods like cars and washing machines, fell 0.5% April through June, after increasing by 19.8% January through March.  But spending on consumables known as non-durables rose by 1.7%.

The growth in business spending also showed a decline as second quarter spending increased by 2.7%, as compared to 13.7% in the first quarter.  Investment in structures contributed the greatest amount of the gain as it rose by 12.7%.  Equipment and software fell by 1.0% which echoes the anemic earnings outlook by computer and software manufacturers.

Corporate earnings will likely slow this quarter.  Standard & Poors believes the S&P 500’s record 16 consecutive quarters of year-over-year double-digit operating gains will end during the second quarter of 2006.  S&P expects earnings growth to be 9.1% for the second quarter once all companies have reported.  And recent earnings growth has not come purely from improved business results.  Earnings gains have come in large part from reduced share count as over 50% of the S&P 500 companies significantly bought back shares of their own stock.  Further, net interest income is expected to grow 64% this year for the S&P Industrial (Old) companies, which translates into 3.6% earnings growth for 374 companies in this group,” noted Howard Silverblatt of S&P.

Performance within the S&P 500 has also varied widely, with Utilities and Energy leading the way and Materials and Industrials expected to report 13.82% and 10.57% growth in operating earnings, respectively.  Conversely, Information Technology is projected to post lower year-over-year earnings (-1.85%), and Consumer Staples will likely be down (-0.66%).  All of the other sectors are expected to report single-digit earnings growth.

Earlier in the week the Federal Reserve released its “beige book” report on regional economic activity.  The Wall Street Journal points out that its findings that economic growth slowed around the country may give the Fed an added reason to stop raising interest rates soon, though not necessarily at its Aug. 8th meeting. Futures markets currently put even odds on the Fed either raising its short-term rate target to 5.5% at that meeting, or leaving it at 5.25%.  The stakes of each Fed meeting going forward rise for investors as the economy seems less invincible than before.  Will Mr. Bernanke hold the course to wait for inflation to recede?  We hope so.