GDP Growth Slows, Inflation Climbs

July 28, 2006 — -- The U.S. government today announced a sharp slowdown in economic growth for the April to June period. The Bureau of Economic Analysis released its first look at the overall U.S. economy today, which showed a 2.5 percent annualized growth, well below the sizzling 5.6 percent growth in the first quarter.

The slowdown was expected, but a dip of this size is more significant than what most economists were betting on (economists had expected gross domestic product growth of about 3 percent in Q2).

Data show that the leading causes of the slowdown were consumers' pulling back their spending, specifically on cars and big-ticket items; businesses knocking down their purchases of computers and software; and a tailing off of exports. A falloff in the housing market took about a half percent off the result.

Even more exciting than the slowdown is the uptick in inflationary pressures. According to this first of three looks at Q2, prices for purchases increased by 4 percent Excluding volatile food and energy prices, prices increased 2.9 percent, well above the comfort zone for the Fed.

Never fear -- the economy isn't crashing.

After the first quarter's sizzling performance, a correction in GDP growth was needed. No developed economy can sustain a 5.6 percent growth rate with low unemployment (now at 4.6 percent in the United States). So today's news, which showed a deeper cut in growth than was expected, isn't a horrible situation. We're bringing things back to a level that can be sustained over time.

That said, the slowdown coupled with real inflationary pressure, poses a conundrum to the U.S. Federal Reserve. The Fed governors raise interest rates to defuse inflationary pressures by slowing the economy. But today's report shows a slowing economy with increasing prices.

If the central bankers continue to raise rates (the next meeting is scheduled for Aug. 8), they could check those rising prices but push the slowing economy into recession. The markets are betting on a pause in August, but today's report muddies the waters a bit.