The Commerce Department reported last Friday that Gross Domestic Product rose at an annual rate of 2.1% in the 2Q, down from 3.1% in the 1Q. This was the so-called “advance” estimate which will be revised two more times, at the end of August and again at the end of September, when more economic data will be available.

While the 2.1% estimate was better than the pre-report consensus of 1.9%, the media would have us believe that the economy is falling off a cliff and headed for a recession later this year or early next year. That’s what they want us to think because they know a continued strong economy is President Trump’s best chance to win re-election next year.

While it is always impossible to know in advance exactly what the economy will do going forward, we do know with the benefit of hindsight why it did what it did in the past. We know, for example, that growth in consumer spending slowed significantly in the 4Q of last year as fears of a trade war intensified, and GDP growth slowed from nearly 3% in the 3Q to only 1% in the last quarter of 2018.

Likewise, we know that US businesses increased their inventories significantly in the 1Q of this year due to fears that President Trump was going to impose significantly higher tariffs on goods we import from China and other countries. As a result, GDP jumped to 3.1% in the 1Q. Mr. Trump has since backed off on those additional tariffs.

As I have reported in recent weeks, most forecasters believed the economy slowed down in the 2Q as businesses pared back their inventory building. Yet even though 2Q GDP slowed to 2.1%, there was some good news in last week’s initial report. Consumer spending which accounts for apprx. 70% of GDP rose almost 3% in the 2Q, well ahead of expectations.

There are reasons to believe the economy will rebound in the second half of this year, despite what the media would like us to believe. As noted above, we know that businesses boosted inventories significantly in the 1Q due to tariff fears. And we now know they cut way back on inventory purchases in the 2Q as fears of a trade war diminished (for now at least).

Assuming inventory purchases get back to normal this quarter, it is useful to look back to see what GDP growth would have been in the 2Q had it not been for the inventory cutbacks. It would have been 3% or better, according to economists at First Trust. That’s very encouraging for the second half of this year.

Assuming consumer spending remains strong and business inventories get back to normal, there is a very good chance the economy recovers to 3% growth in the second half of this year. I believe there are solid reasons why this could happen just ahead.

Fed Yields to Media Pressure & Cuts Interest Rates Prematurely

The Fed Open Market Committee (FOMC) met on Tuesday and Wednesday of this week and voted to cut the Fed Funds rate by 25 basis points (0.25%) as was widely expected. The new Fed Funds target range is 2.00%-2.25%, down from 2.25%-2.50%.

As regular readers know, I and others have argued against a rate cut at this time since the economy remains very robust and the unemployment rate is near a 50-year low. Despite that, the Fed Funds futures market has been locked in at a 100% probability of a rate cut at this week’s FOMC meeting.

The Fed’s policy statement released at the end of yesterday’s meeting indicated the FOMC remains concerned that the global economy is losing some of its momentum, which might explain the rate cut. Yet as I discussed above, the US economy could very well rebound in the second half of this year. The Fed has to know that. So, there must be something else concerning the Fed.

In addition to the economy, the Fed is also very sensitive to inflation, which has remained below its 2% target all year. The Commerce Department reported yesterday that the Personal Consumption Expenditures Index (PCE), the Fed’s favorite inflation indicator, rose only 1.4% over the year ended June 30, as you can see in the chart above.

This may well be the explanation for the Fed cutting rates during a strong economy. The Fed is deathly afraid of deflation (falling prices). We’ll know more about the Fed’s thinking in a few weeks when the minutes of this week’s meeting are made public. I’ll keep you posted, of course.

Finally, in his post-announcement press conference, Chairman Jerome Powell said the Fed does not expect more rate cuts at subsequent FOMC meetings, unless conditions change. US stocks immediately plunged lower as traders fully expected more rate cuts to follow just ahead.