still ultimately about the consumer

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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

Good morning. The S&P 500 hit another record yesterday and is now 14 per cent off the low of late March. Strong earnings reports from companies ranging from Google to Caterpillar to Eli Lilly helped, as did a lower oil price. But this feels, suddenly, like a market that doesn’t need a catalyst to rise. Some people will find that encouraging, others frightening. Let us know which type you are: [email protected].

US GDP

The first-quarter US GDP report, which landed yesterday, showed a real growth rate of 2 per cent annualised — a bit lower than the 2.2 per cent economists expected, but hardly a big disappointment. The economy’s long-term trend rate is probably lower than that, given that the population is hardly growing.

What got everyone’s attention, once again, was slowing consumer spending. It came in at a 1.6 per cent annual rate, down from 1.9 per cent in the fourth quarter of 2025. That’s not a terrible number, either, but a corresponding fall in the personal savings rate indicates some consumers are spending more than they earn. With higher gas prices on the way, it is easy to imagine a lower number in the current quarter.

The other big news was the sharp increase in private fixed investment. Data centre construction fell, but digital equipment and software — what goes inside the completed structures — soared.

Unhedged warned against concluding that AI capex is the only thing keeping the US economy out of a recession. Remember that the imports that go into the data centres (chips and the like) create an offsetting deduction from the GDP calculation. And consumer spending is such a large item that a much lower growth rate still amounts to an almost equally large contribution to aggregate GDP growth:

Is there a tension between softening personal consumption and rising corporate investment? Steven Blitz at TS Lombard notes that the two have had a strong correlation historically. Looking back to the 1990s, tech capex growth was matched by an even greater expansion in discretionary consumption. In essence, “consumer spending functioned as a prerequisite for sustained capex”, Blitz says. But now it looks like AI capex is set to rise above consumer spending as a contributor to GDP growth. Chart courtesy of Blitz:  

It is not clear to us this pattern reflects causation or just correlation. The link between consumer spending and tech capex could be explained many different ways. Over the long term, tech investments should, directly or indirectly, yield products that consumers buy. If consumption stays weak, the investments will have been wasteful. But there is always going to be mismatches in the timing.

(Kim)

Central bank hold ’em

Both the European Central Bank and Bank of England held rates yesterday, as everyone expected. The ECB kept its deposit rate at 2 per cent; the BoE voted 8-1 to stay at 3.75 per cent, with chief economist Huw Pill the lone dissenter for a 25-basis-point increase.

Nothing to see here? Not quite. Both banks are facing the first-round effects of an energy supply shock caused by the Iran war and their regions’ dependence on imported energy. That’s beginning to show up in the data, but it’s not yet persistent enough to warrant a policy reaction.

Monetary policy operates on the demand side of the economy; the standard prescription for supply shocks is to look past their immediate effect on inflation. Hence the ECB and BoE holding fire.

Monetary policy also operates with a lag. A rate rise today could take effect after the shock has disappeared from headline inflation. But waiting too long increases the risk that a stronger reaction will be required later.

This is what happened in 2022. Central bankers spent the better part of a year arguing that the post-pandemic rise in inflation was transitory, only to reverse course and rapidly raise rates after the Russian full-scale invasion of Ukraine.

But this is not 2022. The UK and euro area are experiencing this shock from a different starting position. Both are facing weak growth and labour markets that are already showing signs of slack. So both can wait to see if higher energy prices become embedded in wages and higher inflation expectations.

For the BoE, the soft labour market will be critical to containing inflation:

The ECB will have to make up its mind by June. The surge in energy prices is already passing through to higher inflation expectations, and at 2 per cent its monetary policy stance has been roughly neutral for almost a year. Markets are pricing in up to three interest rate rises by the end of the year, up from none before the start of the war.

The BoE appears willing to wait a little longer. Higher energy prices are already weighing on economic activity. However, the full impact on households will not be felt until the third quarter, when the energy regulator resets its price cap. While UK financial conditions are already considered restrictive, it’s not at all clear that will free the BoE from having to crank up rates later in the year. Under each of the three energy price and inflation scenarios it set out, the policy rate ends the year higher.

The ECB and BoE can be forgiven for their caution. This shock was not of their making. But the longer it lasts, the less tenable inaction becomes.

(MacFadden)

One good read

Why Powell is right to stay.

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