US Q1 GDP still in negative zone; as PCE inflation tapers to 2.1%

2 Jun 2025 , 10:57 AM

US Q1 GDP STAYS IN CONTRACTION MODE

The contraction in GDP in the first quarter of 2025 is for real. The first advance estimate of US Q1GDP showed -0.3% contraction, while the second estimate shows marginally improvement at -0.2%. The moral of the story is; the contraction is for real! The fall in GDP was largely an outcome of a spike in imports, which is what the data also shows.

Economists believe this could be a one-off event as importers front-ended imports ahead of the tariffs. A lot will depend on whether and how tariffs pan out. If we were to compare the first estimate with the second estimate of US Q1GDP, the 10 bps improvement is largely due to improved investments, even as consumption has seen additional stress.

CONSUMPTION AND GOVERNMENT SPENDING FALTERS IN Q1

Interestingly, with the DOGE initiative and Trump trying to prune government costs, even government spending contracted in the first quarter. The goal of lower imports and a lower trade deficit has, perhaps, been partially achieved, but this has been achieved at the cost of contraction in GDP. The question is; whether it was worth it?

This is the first negative quarter for US real GDP, since Q1-2022. Back then, the real GDP was hit by a sharp spike in inflation. In Q1-2025, real GDP is in negative zone despite very low levels of inflation; which is an area of concern. For Q1-2025, non-durable goods grew at 2.2% and services at 1.7%. However, durable goods GDP put pressure, contracting -3.8%.

PCE INFLATION FALLS 60 BPS IN TWO MONTHS

The personal consumption expenditure (PCE) inflation is announced towards the end of the month, unlike CPI inflation that is announced in the middle of the month. The Fed uses PCE inflation as the benchmark for deciding on rate action. PCE inflation looks at inflation from the perspective of personal financial consumption. Thus, it factors in prices and spending habits; making it more reliable as an indicator for Fed policy.

When reciprocal tariffs were announced by Trump, there were concerns that higher import tariffs would escalate inflation in the US. After all, the US economy runs a large trade deficit. However, in reality, the US government put reciprocal tariffs on hold for 90 days and in the last 2 months, the PCE inflation has fallen by 60 bps from 2.7% in Feb-25 to 2.1% in Apr-25.

WHAT PULLED DOWN PCE INFLATION TO 2.1% IN APRIL 2025?

If one looks at the break-up of PCE inflation in April, it was driven by direction of consumer spending. For instance, consumer spending is higher in services like housing, healthcare, food services, accommodation, and transport. Goods saw contraction in consumption spending due to lower spending on food & beverages, clothing & footwear, motor vehicles, and recreational goods. Financial services was one of the few services contracting in April.

What explains the 50 bps fall in PCE inflation in last 2 months. Core inflation fell from 2.9% to 2.5% in this period, while food inflation moved higher from 1.5% to 1.9% in this period. However, the biggest trigger for the fall in PCE inflation in last 2 months has come from the Energy basket, which has moved from -1.2% in February 2025 to -5.5% in April 2025. Weak crude prices is making all the difference.

CME FEDWATCH – STICKS TO 2 RATE CUTS IN 2025

Ideally, lower PCE inflation and weak GDP should have raised the probability of rate cuts, but that has not been the case. Here is a quick dekko.

Fed Meet	200-225	225-250	250-275	275-300	300-325	325-350	350-375	375-400	400-425	425-450
Jun-25	Nil	Nil	Nil	Nil	Nil	Nil	Nil	Nil	2.2%	97.8%
Jul-25	Nil	Nil	Nil	Nil	Nil	Nil	Nil	0.5%	22.0%	77.6%
Sep-25	Nil	Nil	Nil	Nil	Nil	Nil	0.3%	14.3%	57.8%	27.6%
Oct-25	Nil	Nil	Nil	Nil	Nil	0.2%	8.1%	38.5%	41.0%	12.3%
Dec-25	Nil	Nil	Nil	Nil	0.1%	5.7%	29.4%	40.3%	20.8%	3.7%
Jun-26	Nil	0.1%	1.4%	6.8%	17.9%	27.9%	26.4%	14.6%	4.4%	0.5%
Dec-26	0.3%	1.5%	5.5%	13.6%	22.6%	25.5%	19.1%	9.1%	2.5%	0.3%

Data source: CME Fedwatch

Here is what we read from the probability table.

• The first rate cut in 2025 only looks likely in the September 2025 meeting. At that point, the probability of 25 bps rate cut to 4.00%-4.25% stands at 72.4%. Rate cuts by the Fed appear almost unlikely in the June and July Fed meetings.
• How many rate cuts are expected by the end of 2025? If one looks at the probability of rate cuts by December 2025, there is a 75.5% probability of 2 rate cuts by December 2025. That means, the Fed is likely to follow up its September rate cut, with another rate cut, as early as October 2025 itself. So, 2 rate cuts in 2025 are still likely to happen.
• The situation in 2026 is hazy due to the uncertainty over tariffs. After 2 rate cuts of 25 bps each in 2025, there is a high probability of another 25 bps rate cut in 2026, with very modest probability of an additional 50 bps. The level of Fed rates by end of December 2026 may realistically be in the range of 3.50%-3.75%; and optimistically 3.25%-3.50%.

Jerome Powell of the Fed has underlined time and again (including in the latest FOMC minutes) that the disruptive impact of tariffs could be very high. Hence, the Fed needs to keep weapons in its arsenal to fight inflation, should it spike post-tariffs. The most likely scenario at this juncture is an additional 50 bps rate cut by end of 2025 and another 25 bps rate cut by end of 2026.