Second quarter GDP growth slows, but better consumer spending is a hopeful sign

First, the bottom line: Stronger consumption provided the key growth catalyst in Q2

• Headline growth slowed in the second quarter, but the resurgence in the consumer sector suggests a healthy rebalancing within the economy to one that’s less reliant on AI-related investment as a primary driver of growth to one in which consumers show greater confidence and improved willingness to spend.

By the numbers: Headline moderation masks consumer sector improvement

• The U.S. economy expanded at a 1.5% annualized pace in the second quarter, according to the first estimate, a result that reflected some moderation in growth from the first quarter 2.1% pace.
• Beneath the headline, the underlying story was more nuanced.
• The consumer picture brightened considerably. Coming off a very tepid consumption gain in Q1, personal consumption growth accelerated to 3.2% in Q2, with the improvement most notable in goods spending but still extending to the service sector.
• That improvement also extended to housing, which grew by 1.5%, snapping a string of five consecutive quarters of contraction. That doesn’t mean that the housing market is “back” but at least points to the potential for some stabilization after a very rough stretch.
• Business investment, which had taken the baton of leadership from consumers, weakened, but remains a positive contributor to the overall growth story.
• Even so, inventory depletion trimmed headline growth by nearly 0.7%, creating a headwind that could reverse in the coming quarters if business sentiment and the outlook for consumers remain constructive. The trade deficit also weighed heavily, trimming 1% from top-line growth.
• Boil it all down, and growth slowed overall, but with some hopeful signs of some normalization in the consumer sector. It’s still not an economy that’s firing on all cylinders, but it’s starting to look like one that’s less reliant on business investment to carry the primary burden of growth on its back.

Now, about the Fed…

• Growth moderated in the second quarter, coming in below forecasts, while providing some hopeful signs of improvement in the important consumer sector.
• Consumers opened their proverbial pocketbooks a bit more freely across the board, with spending accelerating for both goods and services.
• That improvement came despite signs that inflation — a major source of frustration in recent years — remained on an uptick. The headline PCE index surged to 5.1% from 4.6% in Q1, although core inflation moderated by a full percentage point to 3.4%.
• By any measure though, inflation remains elevated — well above the 2% target that the Kevin Warsh-led FOMC reiterated yesterday on the back of their decision to leave the central bank’s benchmark policy rate unchanged at 3.5–3.75%.
• The decision to hold steady on rates was muddied by a tone that was more hawkish than many had anticipated, reinforced by three FOMC members voting for a quarter-point hike.
• The brevity and bluntness of the FOMC’s statement accompanying their decision raised plenty of questions and sent equity markets spinning as investors tried to absorb the totality of the Fed’s message — both what was said and what was notably left unsaid.
• “The Committee will deliver price stability” was a direct, unambiguous commitment to fix the inflation challenge — the kind of message that would typically be music to the market’s ear. Against the current inflation backdrop, however, that resolute promise raised a few obvious questions around the decision not to take a quarter point yesterday and, perhaps as importantly, what exactly the Fed is looking for as its cue to take that step. The market reaction was swift, as long-bond yield rose and equities sold off.
• New Fed Chair Kevin Warsh made it clear at his June press conference that changes were coming both in terms of the FOMC’s communication style and use of forward guidance.
• Warsh doubled down yesterday. The change in communication style was as clear as the message was murky, reinforcing the marked change in tone from the Fed that significantly deemphasizes transparency in favor of strategic ambiguity.
• The combination of explicit and implied takeaways left Fed-watchers rubbing their temples as they tried to fill in the gaps left by limited guidance: the 2% inflation target is intact and inflation remains high, but a majority of the committee didn’t feel strongly enough about it to take action, and Chair Warsh had no intention of providing insights into what the path ahead for rates will be or even what might drive their decision.
• Markets can adapt and they inevitably will. Still, the closing of the curtain on the behind-the-scenes aspects of policymaking and expectations after many years focused on increased transparency is a meaningful change. Adapting to this new approach and embracing its practical implications are two different things entirely. Markets hate uncertainty, and the change in the Fed creates that.
• That likely means increased volatility around rates, the potential that rates could be higher for longer, and capital markets that will likely experience greater bouts of volatility as interest rates and fed policy expectations evolve.

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