Trade gap widens, second quarter GDP growth softens

The monthly trade deficit is always volatile. The advance look at the goods trade deficit widened sharply in May. As a result, we have reduced our second quarter GDP outlook from 2.6% to 2.0%. Despite the softer growth outlook for the quarter that just ended, the markets continue to price in one 0.25% rate hike between now and year-end. We agree. The major issue for the Federal Reserve currently is the outlook for inflation. We think the overall CPI will decline somewhat in both June and July as the recent sharp drop in oil prices filters through into the economy. But the core rate will be little affected. Fed Chair Warsh and his colleagues seem to be serious about reining in the inflation rate to the targeted 2.0% pace. If that is the case, they need to demonstrate their commitment to achieving that objective via a modest rate hike in the months ahead.

The economy seemed to be tracking nicely at about a 2.5% pace in the second quarter. But the advance trade deficit for goods in May surged from $83.0 billion in April to $105.8 billion. Exports plunged by about $14 billion in that month as industrial supplies — a category that includes crude oil and petroleum products — accounted for about one-half of the drop. Imports climbed by about $9 billion, much of which was in the capital goods category, which includes computers and accessories, semiconductors and telecommunications equipment. It is clear that the war with Iran has severely disrupted trade with the Middle East. At the same time, there has been a steady flow of equipment into the U.S. for data center buildout. Having said all that, on those occasions in the past when the trade gap surged in one month, it seems to fall sharply in the subsequent month. That is what we are expecting to happen in June.

We get our first look at second quarter GDP growth on Thursday morning, July 30. We are expecting growth of about 2.0%. Other economists are almost certainly trimming their growth forecasts, and it is not yet clear where the consensus will be. GDP growth of about 1.5% is probably not a bad guesstimate at this point.

The next FOMC meeting will be July 28-29. While this is a day or so prior to the official release of the GDP report, the Fed will clearly have an advance look at what that growth rate will be.

If second quarter GDP growth has softened to 1.5%, how much does this influence policymakers at the Fed? Probably not much. The primary culprit for the weaker growth is trade, which should subtract at least 1.0% from the second quarter GDP growth rate. Eliminate the trade component and second quarter growth would be about 3.0% rather than the 1.5%-2.0% pace we are likely to see. The economy still seems to be expanding nicely.

Meanwhile, the stock market is very close to its record high level. The unemployment rate, at 4.2%, is at its full-employment threshold, at which point everybody who wants a job has one.

The remaining variable is inflation. The dramatic drop in oil prices in the past month should cause the overall CPI to decline slightly in June. The year-over-year increase should slow from 4.2% to 4.0%. The core rate, meanwhile, is estimated to increase 0.2% in June, which suggests the core rate for the past 12 months will remain at 2.8%. The Fed has indicated emphatically that it wants to see the inflation rate slow to 2.0%. As a result, we expect the Fed to raise the funds rate by 0.25% at its July meeting to demonstrate that it is, at long last, serious about reducing the inflation rate to 2.0%.

Dramatic changes in the trade deficit can significantly alter the GDP outlook for any given quarter. But because the trade deficit can flip back in the other direction in the following month, one has to be careful in readjusting the GDP outlook based on the trade deficit for any given month. In the end, we are all largely guessing.

From 1980 until his retirement in 2003, Stephen Slifer served as chief U.S. economist for Lehman Brothers in New York City, directing the firm’s U.S. economics group while also being responsible for forecasts and analysis of the U.S. economy. He has written two books on using economic indicators to forecast financial markets and previously served as a senior economist at the Board of Governors of the Federal Reserve in Washington, D.C. Slifer can be reached at www.numbernomics.com.