June 2006

Slower Growth, Contained Inflation

Real GDP growth seems likely to slow, reflecting a marked deceleration in consumer spending and a deteriorating outlook for private residential investment. Although inflation has come in above forecasts, long-term inflation expectations appear contained. Decelerating labor costs and high profit margins should help limit inflation pressures going forward.

Consumer Spending and Residential Investment Drag Down GDP Growth
Real household spending growth has been gradually slowing over the past 2½ years, due to energy-price increases. Chart 1 shows PCE chain-price inflation, both with and without energy, and nominal household spending growth. As evidenced by the difference between overall inflation and core inflation, energy-price inflation has been trending upward. Meanwhile, household spending growth has held steady. Real household spending growth—the difference between nominal spending growth and overall PCE inflation—has been squeezed.

Real consumer expenditures appear to have decelerated sharply in the second quarter, pulling down GDP growth. Chart 2 shows annualized monthly growth rates of real personal consumption expenditures.

Additional evidence of a deceleration can be seen in the housing sector. As shown in Chart 3, home permits and real private residential investment move closely together. The fact that permits peaked in September 2005 and have since declined sharply suggests that residential investment fell in the second quarter. Other indicators are sending similar signals, and the housing sector seems likely to remain a drag on the economy into the second half of the year.

Weak Labor-Cost Increases and High Profitability Help Limit Inflation Concerns
Inflation has increased over the last couple of months but remains within the range established over the recent past. Chart 4 illustrates using 12-month core PCE inflation, which excludes food and energy prices, and the Dallas Fed’s trimmed-mean PCE inflation measure, which excludes extreme price changes regardless of the goods and services involved. Note that trimmed-mean inflation has stayed between 2.0 and 2.5 percent for nearly 2½ years now. Widen the range to 1.5 to 2.5 percent, and trimmed-mean inflation hasn’t strayed since 1993, except during a nine-month period in 2001.

Long-term inflation expectations have also stayed within a relatively narrow, 50-basis-point range in recent years. Chart 5 shows 10-year inflation expectations from the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters and inflation expectations calculated as the difference between the yields on standard and inflation-protected government bonds. The survey expectations hold nearly constant at 2.5 percent. The expectations calculated from bond yields were 2.58 percent in late June, down from 2.7 percent in early May.

Helping to restrain inflation is a combination of low compensation growth and high productivity growth. The result has been nearly constant unit labor costs. Chart 6 shows labor-cost growth in the nonfinancial corporate sector, along with product-price inflation. The recent gap between price inflation and cost inflation has gradually widened profit margins. But competitive pressures tend to normalize these margins over time. So, if cost growth can be contained, market forces should help limit future inflation.

In summary, because of slowing consumer spending and declines in home construction, second-quarter GDP growth was likely fairly weak. Inflation has been disappointingly, but not exceptionally, high. Looking ahead, stable long-run inflation expectations and slow growth in labor costs provide encouragement that inflation will remain contained.

—Evan F. Koenig and Nicole Ball