Did Markets and the Government Just Get Real about Inflation?

I’m not going to comment much at this point on the GDP report that came out, except to note that, while “real” GDP growth came in lower than most economists expected, it came in higher than I expected and higher than I believe is likely true. However, what stands out—even if the still mediocre GDP growth rate is accurate—is the inflation rate that came screaming through! It’s hard to say this time the government didn’t subtract enough for inflation to get GDP real because, at last, what they subtracted for inflation almost looks like an honest number:

Red-hot inflation. The GDP deflator, which tracks inflation in the entire economy (consumers, businesses, and governments) soared by 6.3% in Q2 annualized. Not adjusted for this red-hot inflation, “current dollar GDP” jumped by 7.9%. But adjusted for inflation, “real GDP” rose by only 1.5%, according to the GDP data from the Bureau of Economic Analysis today.

“Real” GDP overall grew by only 1.5%, dragged down by this red-hot 6.3% inflation. (Wolf Street)

The “deflator” is the percentage rate the Bureau of Economic Analysis subtracts out of raw GDP growth to make up for what inflation falsely added to GDP because GDP measures production in dollars, not units of goods and services produced, and its goal is to only report on domestic production. Mathematically, the number you subtract out to get rid of a percentage increase that hit GDP simply due to rising prices is always smaller than the percentage increase it took to drive prices up because you are working from a larger number, so it takes a smaller percentage to subtract out the same number of dollars. So, backing out 6.3% looks real…at least, at first blush.

While I am leery, regardless, about believing in the 1.5% real GDP growth rate, it’s still shows weak growth, at best:

In the years between the Great Recession and the pandemic (so excluding recessions), average quarter-to-quarter GDP growth was 2.5% annual rate. The average 20-year quarter-to-quarter GDP growth, including recessions, was 2.2% annual rate.

So, 1.5% real GDP growth is certainly nothing to boast about, and we’ve often seen these initial GDP numbers revised down in the next report.

While GDP growth was weaker than economists had expected, the inflation rate is attention-getting, considering it includes a good part of the period when fuel prices (and the crude prices behind them) dropped during another failed Trump schmeasefire.

The future of inflation

If you look at the news below on the major changes in the war, you will see that the price situation for fuels and electricity is certainly going to get worse. I anticipate covering the changes in the war and recently significantly more dangerous headlines about the war in my weekend Deeper Dive for paying subscribers (barring some even more interesting news to come along).

Also, a fascinating change came through at the Fed that I hope to cover where it is clear from bond yields, following the Fed meeting, that the bond market does not believe inflation is going to remain at current levels and is doing the heavy lifting now to raise interest rates, regardless of what the Fed does … in anticipation of even worse inflation (like I have been assuring you IS coming).

The fascinating part is that Kevin Warsh said repeatedly, after the Fed FOMC meeting, that bonds taking over is exactly what he wants! I’ve never heard the Fed say that. Market analysts in the news took the bond market's response as a huge fail for Warsh’s big meeting. However, Warsh said he wants to see the US economy go back to markets doing the actual heavy lifting of interest rates to curb inflation, rather than the Fed, and what he sees is markets reacting more strenuously to the threat of inflation now that the Fed is backing out of its constant manipulation. That will likely merit further exploration to see how serious he is about the Fed backing off on its DECADES of market manipulation and coming in only if markets fail to raise rates when higher rates are needed.

Some say, that the crash in bond prices (soaring yields) proves the market doesn’t believe Warsh can control inflation. He says, however, it means they’re waking up to the reality that the Fed intends to let markets do the kind of self-correction that capitalism is supposed to be capable of when the “experts” are not always trying to rig the markets and the economy. He says they’re getting the point and getting on with it because he is refusing to give them even a hint of forward guidance, so they’re forced to figure things out on their own, rather than just bet based on what the Fed hints it will do next, which has always turned stocks into a casino that largely bets on the Fed and has made bonds lazy. That’d be nice if it’s true, though the transition back to market-based reality may be a rough ride.

See you in the Deeper Dive, where I’ll dig into the larger turns in the war that happened and maybe find time to dig deeper into the Warsh Factor, which, of course, market analysts/brokers already seem to hate because they have been able to play a lazy rigged game for a long time that has stuffed a lot of Fed funds into their pockets. (But, again, this is my superficial glance at Warsh’s words, and that needs some deeper digging.)