The latest GDP report from the Bureau of Economic Analysis has drawn attention not so much for its growth figures as for the inflation data embedded within them. While "real" GDP growth came in lower than most economists expected, the inflation rate reflected in the report stands out as notably elevated.

The GDP deflator, which tracks inflation across the entire economy — including consumers, businesses, and governments — soared by 6.3% on an annualized basis in Q2. Not adjusted for this inflation, "current dollar GDP" jumped by 7.9%. But adjusted for inflation, "real GDP" rose by only 1.5%, according to the BEA data. (Wolf Street)

The deflator differs from the more widely cited Consumer Price Index in that it captures price changes across all domestic production — government spending, business investment, and exports included — rather than only a basket of consumer goods and services. This makes it the BEA's broadest single gauge of economy-wide inflation.

The "deflator" is the percentage rate the Bureau of Economic Analysis subtracts from raw GDP growth to account for what inflation falsely added to GDP. Because GDP measures production in dollars rather than in units of goods and services, the deflator's purpose is to isolate genuine domestic production. Mathematically, the number subtracted to remove a price-driven increase is always smaller than the percentage increase that drove prices up, since it is calculated from a larger base. At first glance, backing out 6.3% appears consistent with the actual inflation picture.

Even if the 1.5% real GDP growth figure is accurate, it represents weak growth by historical standards. In the years between the Great Recession and the pandemic — a period excluding recessions — average quarter-to-quarter GDP growth was 2.5% at an annual rate. The average 20-year quarter-to-quarter GDP growth, including recessions, was 2.2% at an annual rate. Initial GDP figures have also frequently been revised downward in subsequent reports, as this release is the advance estimate — the first of three versions the BEA will publish, each incorporating more complete source data.

The combination of above-trend inflation with below-trend real growth echoes the stagflationary pattern that characterized much of the 1970s, a period when similarly persistent inflation eroded purchasing power despite positive headline GDP numbers.

Notably, the Q2 inflation reading covers a period that included declining fuel prices — and the crude oil prices behind them — during what the author describes as a failed ceasefire initiative under the Trump administration. Despite that temporary reprieve in energy costs, the deflator still registered a substantial increase.

Bond Market Takes the Lead on Rate Expectations

Following the latest Federal Open Market Committee meeting, bond yields moved markedly, suggesting that the bond market does not believe inflation will remain at current levels. The market appears to be doing the heavy lifting on interest rate expectations independently of the Fed's actions, positioning for potentially higher inflation ahead.

Kevin Warsh, speaking repeatedly after the FOMC meeting, indicated that bonds taking over this role is precisely what he wants — a stance that, according to the author, is unprecedented in recent Fed communications. Market analysts widely interpreted the bond market's sharp response as a failure of Warsh's meeting. However, Warsh framed it differently, stating that he wants to see the U.S. economy return to a system where markets perform the actual work of setting interest rates to curb inflation, rather than relying on the Fed.

Forward guidance — the practice of signaling future policy moves to steer market expectations — has been a cornerstone Fed tool since the 2008 financial crisis, when the central bank used it to anchor rates near zero for years. Warsh's reported refusal to continue that practice marks a departure from the approach of the Bernanke, Yellen, and Powell eras.

Under Warsh's stated vision, the Fed would step back from decades of market manipulation and intervene only if markets fail to raise rates when higher rates are needed. Some observers argue that the crash in bond prices — and corresponding surge in yields — proves the market lacks confidence in Warsh's ability to control inflation. Warsh, however, characterized the reaction as evidence that market participants are awakening to the reality that the Fed intends to let markets self-correct, as a capitalist system is designed to do when regulators are not constantly intervening.

Warsh reportedly noted that by refusing to provide forward guidance, he is forcing market participants to assess conditions independently rather than placing bets based on Fed signals — a dynamic that he suggested has turned stocks into a casino and made bonds complacent. The transition back to a market-based rate environment, if it materializes as Warsh describes, could prove volatile.

The author, David Haggith, is the publisher and editor-in-chief of The Daily Doom, a non-partinent daily collection of economic, social, and political news from sources around the world.

Source: GoldSeek