2% growth and 2% inflation: the Fed's done

This brief post highlights some under-appreciated news contained in today's revised estimate of Q2/23 GDP. Real growth in the quarter (annualized) was revised down from 2.4% to 2.1%, and inflation (according to the all-encompassing GDP deflator, also annualized) was revised down from 2.2% to 2.0%. We're very much in a 2% growth world, as I noted last May. Inflation, meanwhile, has plunged from a high of 9.1% a year ago to a mere 2.0%.

These facts lay bare the false belief that inflation is the by-product of an economy that is "running hot," and that in order to bring inflation down the economy must suffer a period of "below-trend" growth. It just doesn't work that way. The economy has been growing at a sub-par rate since 2009, while inflation has been all over the map. Inflation is the result of too much money relative to the demand for money. 

These facts also highlight just how wrong the market is to worry that the economy is "too strong" and therefore the Fed must keep short-term rates at a high level for an extended period. I see the 3.4% rally in the S&P 500 over the past 12 days as evidence that the market is just beginning to appreciate these facts. 

Chart #1

Chart #1 shows the path of real GDP compared to two different trend lines. (Note: the y-axis uses a semi-log scale which shows constant rates of growth as straight lines.) The 3.2% trend was in effect from 1955 through 2007, while the 2.1% trend has been in effect since mid-2009. This highlights the grim reality that the U.S. economy has been suffering from a prolonged period of sub-par growth, thanks mainly to unusually high regulatory and tax burdens, coupled with excessive government spending, which in turn has been driven primarily by transfer payments (i.e., sending out checks to people without demanding any work in return).

Chart #2

Chart #2 shows the quarterly annualized rate of growth of the GDP deflator—the broadest, most inclusive, and most timely measure of inflation that we have. (Most folks seem to prefer a narrow, year over year measure of inflation, which is guaranteed to obscure important changes on the margin.) Why don't you see this 2% number in the press? Why is the Fed bemoaning the fact that inflation is still "too high?" Go figure.

One thing for sure: it's only a matter of time before the Fed realizes that instead of keeping rates high for longer, it's time to bring them back down.

P.S. (8/31): Don't forget that as of July, the CPI ex-shelter index was up only 0.85% year over year. See Chart #2 at this post. Shelter costs are almost certain to decline in coming months since they lag the housing market by about one year. And as Chart #3 shows (below), durable and nondurable goods prices have been flat to down over the 12 months ending in July, leaving services (which includes shelter costs) as the only source of inflation.

Chart #3