US Stagnated, but that was Yesterday; Tomorrow's Outlook Brighter

The US economy all but stalled in Q1. The 0.1% annualized expansion was weaker than any quarter last year. However, it is not a harbinger of things to come. Rather, it is a distortion that is not about to be repeated.

There were two main forces at work. First, as anticipated by many economists, including the Federal Reserve, there was a correction to the unsustainable strength of inventory accumulation and net exports. Inventories and exports together took about 1.4 percentage points off GDP. What seemed to surprise some economist was how abrupt the inventories corrected. Many had anticipated the correction would be stretched out over several quarters.

Second, was weather. This appears to have weighed down residential and non-residential investment and may have cut consumer purchases of goods (consumer purchase of services was the best in more than a decade). Utility demand can be linked to the weather, and an increase in health care services are likely related to the Affordable Care Act.

More robust activity is not only a forecast, but is it also a description of what had been taking place in March and April. This point is driven home by today's ADP job estimate, the strongest since last November, and the Chicago PMI was the strongest since last October. The Bloomberg consensus calls 3.0% GDP in Q2 and Q3 before ticking up to 3.1% in Q4.

There is some implication from today's data for the Federal Reserve, but no so much today. The last FOMC statement recognized that Q1 growth would be dampened by transitory factors, including the weather. It may underscore that in today's statement and recognize improved activity. However, the unexpected weakness in Q1 GDP will require a cut in the Federal Reserve's whole year forecasts.

The stagnation of the US economy will most certainly not deter the FOMC from continuing its tapering operation and maintaining the course upon which Bernanke had placed it. This in turn may strengthen the sense that it is almost as if the Fed is on automatic pilot. Another quarter of stagnation, or a sharp deterioration in the labor market or inflation, could prompt a reconsideration of the course.

The yen's modest upticks may, in part, reflect the decline in US yields, but remains in well worn ranges. The euro's gains, on the other hand, are more a function of growing recognition that the ECB is unlikely to take strong action at next week's meeting. Indeed, as we have suggested, the risk of deflation may begin subsiding, even if there is not a large or quick increase. Month end pressures should ease, and EONIA is likely to ease in the coming days.