• Second-quarter real GDP growth came in at 2.5%, below most expectations (around 3.0%) going into the report.
• A decline in residential construction and slower consumer spending growth came as no surprise.
• But business equipment spending, declining for the first time in over three years, was a big disappointment. If businesses are pulling back, the outlook for growth will become much bleaker.
• Growth estimates for the past three years have been revised down, in large part because of new, weaker estimates of business spending on IT equipment.
• Core PCE inflation is continuing to run above the Fed's 1-2% comfort zone.
• We expect growth to remain sub-trend (below 3%) in the second half of the year, but core inflation to edge higher.
• The markets believe that the Fed will focus more on sluggish growth, and not raise rates on August 8.
• Unless Chairman Bernanke and his colleagues shift their tone quickly and prepare the markets for a hike, the Fed will probably stay on hold as the markets expect. But Global Insight still believes that inflation risks mean that the Fed will probably have to hike rates at least one more time this year—if not in August then at a later meeting.

GDP growth came in at 2.5% in the second quarter. This is below expectations going into the report, which were at or just above 3%. We had expected growth to come in above 3%. Although our July forecast completed at the beginning of the month had anticipated just 2.3% growth, recent news for consumer spending, foreign trade, and inventories had all suggested that growth would do better than that.

The biggest disappointment came in business equipment and software spending. This fell by 1.0%, the first decline since the first quarter of 2003. The weakness was concentrated in information processing equipment and software, and transportation equipment. The shortfall in business spending poses an important risk for growth in the second half of the year. Was the second quarter-weakness just a payback for a very strong first quarter, or was it indicative of much more caution in business spending than anticipated?

If businesses are pulling back, then the risks of a sharp slowdown in growth will rise, because a consumer and housing slowdown has been long anticipated and seems to be arriving as expected. Consumer spending growth slowed to 2.5% from 4.8% in the first quarter, as sharply higher gasoline prices took their toll. Residential structures spending declined by 6.3% as the housing market turned down. Revised data shows that residential structures spending has now declined for three quarters in a row. Steeper declines are on the way in the second half of the year as housing weakens further.

Overall spending growth by domestic purchasers slowed sharply to 1.6% in the second quarter from 5.4% in the first. Growth was supported by a faster buildup of inventories and by an improvement in foreign trade. The increase in inventory accumulation is not helpful for future growth. Although inventories still seem lean, if spending growth stays sluggish then inventory accumulation will decline. Export growth slowed, but imports decelerated even faster, probably a reflection of slower domestic spending growth.

On the inflation side, the news in today's release was not helpful. The core personal consumption (PCE) price index, the Fed's favorite measure of inflation, rose 2.9% at an annualized rate in the second quarter and by 2.3% on a year-over-year basis. On any measurement basis, inflation is running above the Fed's 1-2% "comfort zone."

The GDP report includes revisions to the previous three years' national accounts as well as the initial second-quarter estimates. The revisions show slower growth than previously announced, averaging 3.2% from 2002 to 2005, 0.3 percentage point below previous estimates. The key reason for the revision was a lower estimate of growth in real business fixed investment, down to 4.5% from 6.4%. The downward revisions were mainly to information processing and software (especially computers) and transportation equipment (the two items that also disappointed in the second quarter) and to other equipment.

We anticipate that the economy will continue to see sub-trend growth of below 3% in the second half of the year, as housing slides further and consumer spending growth remains sluggish under pressure from high oil prices. But we do not see any relief on the inflation front. Core inflation on a year-on-year basis will probably pick up further, which will worsen the Fed's dilemma.

The markets now expect the Fed to focus more on slowing growth than on inflation risks and take a pause in rate hiking on August 8. The Fed seems likely to validate that expectation—unless in the next few days Mr. Bernanke and his colleagues change their tone and prepare the markets for a hike. But Global Insight anticipates that given continuing upside inflation risks, the Fed will probably have to raise interest rates at least one more time before the end of the year—if not in August, then at a subsequent FOMC meeting.

Raul Dary

24 Hartwell Ave.
Lexington, MA 02421, USA
Tel: 781.301.9314
Cel: 857.222.0556
Fax: 781.301.9416
raul.dary@globalinsight.com

www.globalinsight.com and www.wmrc.com