Fluky GDP Report Stuns Washington; What if It’s Correct?

WHAT A DICHOTOMY — The financial markets shook off yesterday’s fluky first quarter GDP report, while the politicians were stunned. There are big policy implications.

ECSTATIC REPUBLICANS could hardly believe their good fortune, as they ramped up their message that a recession is imminent; they immediately blamed Joe Biden and vowed to resist any new spending or any tax increases. Democrats insisted the report masked a solid underlying economy.

OUR TAKE IS THAT A RECESSION IS NOT IMMINENT, especially with a red-hot labor market and plenty of stimulus still in the system (California is headed for a stunning $80 billion surplus this year). But there’s one troublesome wild card: psychology.

AMERICAN CONSUMERS ARE INCREASINGLY JITTERY, as many pay $100 to fill their gas tanks and are bombarded with negative news: a China slowdown, supply chain issues, the war in Ukraine, etc.

CONSUMERS BELIEVE, incorrectly, that the budget deficit is exploding, and they want less Washington spending. Accordingly, we think yesterday’s GDP report will make it even less likely that Congress will pass any big new spending bills — and a tax hike is out of the question.

THE LEAST APPRECIATED WASHINGTON ECONOMIC STORY is the rapid pendulum shift from fiscal stimulus to fiscal restraint. And with the Republicans likely to easily capture the House in November, the rise of spending will slow even further in 2023-24.

MONETARY POLICY ALSO IS BECOMING LESS STIMULATIVE: Yesterday’s report should have no impact on next week’s likely 50 basis point rate hike, with more to come in the summer. But what if the GDP report wasn’t a fluke? The Fed can’t be absolutely certain.

THUS THERE WILL BE VIRTUALLY NO SUPPORT for a 75 basis point rate hike any time soon, and the possibility — if GDP growth disappoints again — of 25 basis point hikes in the fall, not 50 basis point increases. But that would depend on a deceleration of inflation, which does not appear imminent.

SO THE PSYCHOLOGICAL UNCERTAINTY MAY PERSIST into the summer, as consumer attitudes begin to harden, rejecting Joe Biden’s handling of the economy. Does he have any policy tricks left? Student loan forgiveness is very likely, but the Build Back Better provisions are mostly doomed. A de facto tax cut — a gasoline tax rebate — is possible, mostly at the state level.

BOTTOM LINE: Our mantra is that the froth will be extracted from the U.S. economy. That process clearly is underway, with monetary and fiscal policy tightening — imposed by policymakers who are making a very big bet that the GDP report was a fluke.

Related: The Washington Controversy Over Age Limits

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