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US GDP: Growth Favors Drift up in Market and Fed Funds Rates

GDP grew 4.1 percent, with gains in consumer spending, business investment and government spending—the classic C+I+G of demand. Year-over-year PCE grew 2.2 percent—enough to sustain higher interest rates.

Real Final Sales: Benchmark to Domestic Strength

Despite the headline GDP number, we focus on real final sales as a measure of sustainable economic growth over time. As illustrated in the top graph, this benchmark came in at a 2.9 percent year-over-over gain. This will support the outlook for 3 percent-plus growth in 2018 and continued Fed policy to raise the funds rate in September.

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Real consumer spending rebounded, as expected, at a 4.0 percent pace, with gains in durable and nondurable goods as well as services. Helping the consumer is a healthy labor market, rising disposable income due to tax cuts, improved consumer confidence and the wealth effect of higher home and equity prices. Ahead, rising inflation will limit real income gains, and higher interest rates may already be impacting housing markets.

Government spending also contributed to growth, up 2.1 percent in Q2 with gains in both federal and state/local sectors. Overall, consumer spending, residential investment and government spending all are on a sustainable path to contribute to growth in the second half of this year.

On the downside, residential construction fell 1.1 percent in Q2 after a first quarter decline of 3.4 percent. This remains disappointing relative to many expectations at the start of the year.

Business Investment: Growth Today, Productivity Tomorrow?

Business fixed investment rose 5.4 percent in the quarter, reflecting core capital goods shipments at a slightly slower pace than the first quarter. Structures, equipment and intellectual property all contributed to the gain. Structures have benefited from higher global oil prices.

Looking forward, the issue remains how much the gains in business equipment spending and intellectual property will add to productivity so as to sustain 3 percent-plus growth for 2018 and 2019. The jury is still out.

Inflation: Upward Drift

With the year-over-year change in the personal consumption expenditures (PCE) deflator (2.2 percent) as well as the core PCE deflator (1.9 percent) up relative to the past four quarters, the case remains for the Fed to raise the benchmark funds rate. Service prices rose 2.5 percent in Q1.

For the broader economy, residential prices were up 7.5 percent in Q1, hinting that affordability may be an issue for the weaker-than-expected pace of gains in the housing market.

Therefore, there is a developing theme that we will monitor. Higher interest rates appear to have an impact on the housing market. Meanwhile, the Fed is likely to follow the inflation numbers and raise rates in September while also reducing its balance sheet. We will watch for other signals where higher rates make a difference and hint at the possibility that the Fed will alter the path of rates implied in its dot plot.

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