Fed Speak – Why GDP contraction may be the wrong picture

16 May 2025 , 10:03 AM

FED VICE CHAIR JEFFERSON SAYS, ALL IS WELL

In the US, the Fed does not communicate monetary policy only through its statements and the minutes. There are two other very important ways of communicating monetary policy. The first is the dot-plot chart, where each FOMC member puts a number to their macro projections. These are cumulated and presented quarterly as future projections. The second is Fed speak. Here, the FOMC members speak at key forums and communicate the gist of monetary policy to a discerning audience. In this light the latest address by Fed vice chair, Philip Jefferson, at the Federal Bank of New York becomes relevant. The speech comes in the aftermath of Q1 US-GDP contracting by -0.3% and inflation edging lower to 2.3%. Amidst favourable conditions, FOMC has abstained from rate cuts, despite direct pressure from President Trump. Jefferson explains the rationale for such a stand!

DON’T READ TOO MUCH INTO GDP DATA

Jefferson’s speech to the Federal Bank of New York underplays the Q1 GDP contraction. US GDP had contracted by -0.3% in Q1, against growth of 2.4% in Q4-2024. Jefferson believes this negative number overstates the deceleration in economic activity in the US. According to Jefferson, something Powell also mentioned, GDP contraction was caused by a surge in imports ahead of anticipated changes to trade policy and tariff hikes. This front-ending of imports led to negative GDP growth in Q1. He expects this to normalize from Q2 onwards.

Jefferson has underscored that private domestic final purchases (PDFP) grew 3%, which is a much better gauge of growth. However, with tariffs currently on hold, a trade deal with the UK and a possible sobering of relations with China; GDP growth should pick up. Already, there were signs of spending bouncing back in March, and much of the pressure had come in January and February. The Biege Book had reported a likely impact on demand due to retailers raising prices in tune with higher import tariffs. That could change!

LABOUR MARKET  STILL SHOWS STRENGTH

The labour market can be a good proxy for what is happening to GDP on a sustainable basis. Here are the numbers. Since October last year, the rate of unemployment in the US has been stable between 4.0% and 4.2%. In April alone, the US added 1,77,000 jobs, much higher than the numbers needed to sustain above average growth. Hirings may have slowed, but layoffs remain at historic lows. This resulted in an orderly increase in wages, even as labour supply remains flat. That is evident from the ratio of job vacancies to unemployed workers falling from 2X to 1X, between 2022 and 2025. The labour market is not only signalling sustained growth, but controlled inflation due to orderly hike in wages.

INFLATION FOR NOW AND FOR THE FUTURE?

Jefferson underlined there is a dichotomy between current inflation rate and expected rate of inflation. Both PCE inflation for March and CPI inflation for April are at 2.3%. That is just 30 bps shy of the Fed long term target of 2.0%. However, core inflation is in the range of 2.6% to 2.8%. Core inflation is the residual inflation excluding food and energy. This is structural inflation and is generally reflective of the direction of future inflation.

The future trajectory of inflation remains uncertain. If tariff hikes eventually happen, they can generate a temporary spike in inflation. Street estimates peg PCE inflation in the US touching 4.0% if tariff impact is factored in. A lot will depend on trade policy. The US is inking FTAs with several countries and that could neutralize the inflationary impact of tariffs. Overall, the inflation impact in the near future could be temporary, rather than structural.

WHAT DOES THIS MEAN FOR FED MONETARY POLICY?

That is the billion dollar question. As Jefferson underlined, the Fed continues to focus on its dual mandate of price stability and near full employment. For now, the view is that rate cuts may not be required considering that the Fed had already cut rates by 100 bps in 2024. The Fed members would prefer to evaluate the inflationary impact of tariffs, before committing themselves to rate cuts. That is what even the CME Fedwatch suggests; with the first rate hike of 2025 only likely in September. Trump may be keen to cut rates, but clearly, the Fed is not buying that argument. The Fed has the luxury to wait and watch, and that is exactly what the Fed will do!