Stagflation is a word that might spring to mind on Friday morning after the second-quarter gross domestic product report is released. Because economic growth is expected to rise a healthy 3.7% in the quarter and the GDP price deflator is projected to increase at a 3% annual pace, talk of stagflation -- a stagnating economy with spiraling inflation -- probably sounds like hyperbole and for the most part, it is. But it's easy to see why the term has crept back into investors' lexicon. In recent weeks, real economic growth estimates for the second quarter by Wall Street economists have been revised down by 40 basis points, according to Banc of America analyst Tom McManus. At the same time, forecasts for inflation have risen by roughly the same amount, leaving the nominal rate of growth unchanged. (Real GDP is adjusted for price fluctuations while nominal growth is not.) A similar trend has emerged over the past two quarters, with the rate of real GDP growth slowing as inflation has moved higher. In the first quarter, GDP rose 3.9%, compared with a 4.1% increase in the fourth quarter and 8.2% gain in the third. Meanwhile, the GDP deflator rose at a 2.9% pace in the first three months of the year, up from a 1.5% pace in the prior quarter. The personal consumption expenditure index, a measure of inflation preferred by the Federal Reserve, also has jumped sharply. "If you average the first two quarters of this year, I think growth will end up being a little bit weaker than was expected going into the year and inflation is definitely higher," said Josh Feinman, chief economist at Deutsche Asset Management. "It's been a while since we've had that combination." Still, Feinman said it's premature to suggest that this recent trend will lead to actual stagflation. And McManus agrees, saying he wouldn't be worried unless the rate of real growth fell below the rate of inflation.
One of the main culprits behind decelerating economic growth during the second quarter was consumer spending, which was hurt by higher energy prices. MG Financial Group analyst Ashraf Laidi said spending probably cooled to between 1.8% and 2% in the quarter, down from 3.8% in the first quarter. A 1.8% increase in consumer spending would be the weakest growth since the first quarter of 2001, when the economy was officially in a recession. "But this negative impact is expected to be cushioned by a near doubling in business and residential fixed investment from 5.3% and 4.6% in the first quarter," Laidi said. Laidi thinks the PCE index could rise to 3.5% from 3.2% in the first quarter, with the core rate up to 1.6% from 1.3%. Inflation has been rising this year, largely due to increases in food and energy costs. While it's possible that oil prices will remain high over the coming months (crude briefly touched $43 a barrel Wednesday), food costs could certainly come down going forward. State farmers are already cutting milk prices as new government price limits take effect Aug. 1. The "threshold" price will decrease to $3.31 a gallon from $3.89 a gallon this month. In June, a gallon of milk hit a record $4.43 a gallon, twice as much as a gallon of fuel. Surveys have indicated that health care inflation is also likely to recede next year, and more schools are adopting freezes or caps on tuition rates. Meanwhile, the end of global clothing quotas on Jan. 1, 2005, could result in a new wave of low-cost imports, which could potentially send apparel prices lower. "Suffice it to say that the four groups -- food, medical care, apparel and education -- collectively account for roughly 30% of the consumer price index and could well anchor a surprising downturn in inflation in the coming year," said Merrill Lynch Chief Economist David Rosenberg in a research note.
But while the outlook for inflation remains fairly benign, the outlook for economic growth is also more subdued than perhaps Fed Chief Alan Greenspan has suggested. Despite the Fed's call for more than 5% growth in the second half of the year, the Economic Cycle Research Institute's weekly leading indicator has slowed sharply since the start of the year. The indicator, which leads GDP growth by two quarters and shows a 73% historical correlation, has moderated in six out of the last seven weeks. In the week ended July 16, it had slowed to a 1.1% growth rate, the weakest pace in 15 months. To be sure, recent economic data for July has pointed to some improvement in the economy after a slump in June. Consumer confidence has risen to a 2 1/2-year high and chain-store sales seemed to pick up last week. Many economists fully expect consumer spending to improve in the second half of the year after a disappointing performance in the second quarter. But it's reasonable to expect that GDP will moderate from a very strong pace recently, particularly given persistent high oil prices, a lack of fiscal stimulus and rising interest rates. "We do think we're in a recovery," McManus said. "We just don't think we're in a robust recovery."