The Bureau of Economic Analysis released their report of economic growth and it was disappointing. Even though there was 1.8% growth in real gross domestic product, we typically want to see a figure above 3%. While I agree that we can attribute some of the slower growth to rising gas and food prices, one must also recognize the impact of large government spending cuts, along with worse than expected weather conditions across many regions of the U.S.
It is true that there has been an increase in inflation over the last quarter, but it was not significant. The Federal Reserve Bank of Cleveland reports trends of various inflation measures. Their first measure of the Consumer Price Index (CPI) looks at prices of all items, including food and energy. When calculating quarterly inflation rates, including food and energy, from the 4th quarter of 2010 and 1st quarter of 2011, we see that it increased slightly from 1.27% to 2.13%. If you exclude food and energy prices, then the effect is even more moderate with quarterly Median CPI increasing from 0.6% to 1%. As a guide, most economists actually want some form of inflation with the consensus being around 1-2% as healthy because it allows businesses to increase revenues and create jobs.
Having said that, I do expect inflation to play a more significant role in dampening economic growth in the second quarter. Usually, gas and food prices are volatile in that there is much upward and downward movement each month. However, both have been trending upward consistently. If the trend continues over a long period of time, then we should expect people to be more cautious about their spending habits. Additionally, it is also expected that businesses will eventually have to pass along their increased supplier costs from higher commodity and energy prices to the consumer in the form of higher prices. Right now, a sluggish labor market and tenuous recovery are making businesses reluctant to raise prices across the board.
One might have heard pundits say that raising taxes during slow economy is an ill-fated policy, but they neglect to add that cutting government spending also damages the economy, too. There are actually four components to economic growth: consumer spending, business investment spending, government spending, and net export spending. Of those four categories, only government spending actually witnessed a decline from last quarter. In fact if you took out government spending, the economy would have grown by 2.89%, which would have approximated historical norms. (Note: Refer to Table 2. Contributions to Percent Change in Real Gross Domestic Product.)
The federal and state governments funds programs that sustain jobs in all regions of the U.S. Referring to the federal level, national defense, services, and infrastructure spending impact multiple private businesses that have contracts in place. In particular, there was a decline in defense spending, along with funding from the stimulus package ending which contributed a drop of $30 billion. Portions of that spending would have gone toward economic growth. On the state government side, we are seeing both a reduction in services and personnel as budget constraints are causing expenditures to decline at a rapid rate.
Another factor that should be pointed out is the abnormally bad weather experienced in many segments of the U.S. market. In particular, the Midwest, Northeast, and Southeast suffered through winter storms that kept consumers at home. That could be one factor causing the growth rate of personal consumption expenditures to decline, rather than rising prices. Surely, a sluggish labor market and continued weakness in residential real estate are both relevant factors.
In conclusion, the threat of a double-dip recession remains small despite the lethargic economic performance. However, this should be a cautionary tale about the impact of drastic cuts to the federal government spending before an economic recovery is able to gain steam. Given the mandate to balancing budgets, most states do not have the same level of flexibility, so their options are more limited. When achieving deficit reduction which will provide future benefits in the form of lower interest rates and greater credit access, a more balanced approach where deficit reductions are spread out over a longer period of time might be in order.
Inflation remains a concern and might even have a more negative impact on next quarter's economic growth. The combination of poor global weather and the Federal Reserve's stance on monetary expansion are driving inflation risks up. Currently, the Federal Reserve is reluctant to unwind their quantitative easing program which is aimed at keeping money flowing through the system or raise the federal funds rate. Either policy would slow inflation, but it would come at the cost of higher unemployment. Since labor markets are still operating at below capacity, one can see their reluctance in pursuing that route. However, inflation risks are still moderate now, so it is not expected to unduly affect economic growth in the near future.
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