US Q2 GDP seen at 2.8% as Iran war clouds inflation outlook

The US economy likely expanded at a solid 2.8% annualized rate in the second quarter, but the headline figure masks a surge in inflation tied to the Iran conflict that could complicate the Federal Reserve's policy path.

The Commerce Department's advance GDP report, due for release Tuesday, is expected to show the economy grew at a 2.8% pace in the three months through June, according to the median estimate of economists surveyed by Bloomberg. That would mark a deceleration from the 3.4% rate in the first quarter but still represent above-trend growth for the world's largest economy.

"The underlying composition matters more than the top-line number this quarter because the Iran-related energy shock is distorting both growth and inflation channels," said James Okafor, macro analyst at Edgen. "The Fed is looking at a situation where the economy is running hot while supply-side disruptions from the conflict push prices higher — the worst possible combination for rate-setters."

The GDP report arrives against a backdrop of elevated geopolitical risk. Oil prices have climbed more than 15% since the start of the second quarter after Iran-linked disruptions to shipping lanes in the Strait of Hormuz, a chokepoint for about a fifth of global petroleum consumption. The energy price spike has fed through to broader price measures, with the personal consumption expenditures price index — the Fed's preferred inflation gauge — expected to show core inflation running near 3.5% in the second quarter, well above the central bank's 2% target.

The cross-currents create a dilemma for Fed Chair Jerome Powell and his colleagues. Strong GDP growth argues against rate cuts, while the conflict-driven inflation spike — unlike demand-pull inflation — cannot be addressed by tightening monetary policy without risking unnecessary damage to the labor market. The fed funds rate has sat at 5.25% to 5.5% since July 2023, and OIS markets currently price less than a 40% probability of a cut at the September meeting, down from about 65% before the Iran escalation began in April.

Consumer spending, which accounts for roughly two-thirds of US economic activity, likely remained the primary growth engine in the second quarter, supported by a still-tight labor market. Nonfarm payrolls averaged 218,000 per month over the three months through May, above the 150,000 to 200,000 range that many economists estimate as the breakeven rate for stable unemployment. Business investment in structures and equipment also contributed, though residential investment likely pulled back as mortgage rates hovered near 7%.

The GDP report's price indexes will receive as much scrutiny as the growth figure. The headline PCE deflator for the quarter is expected to show an annualized increase of around 3.8%, while the core measure — excluding food and energy — may come in near 3.5%. Both would represent an acceleration from the first quarter's 3.4% and 3.2% readings, respectively, driven almost entirely by the energy channel.

The last time the US faced a comparable combination of above-trend growth and conflict-driven inflation was during the 1990-1991 Gulf War, when oil prices doubled and the economy slipped into recession shortly after. The current situation differs in that the labor market is significantly tighter and household balance sheets are stronger, but the stagflationary undertones are drawing comparisons among some economists.

Looking ahead, the trajectory of both growth and inflation will depend heavily on the duration and intensity of the Iran conflict. If shipping disruptions persist into the third quarter, the energy-driven inflation impulse could keep the Fed on hold through year-end. A de-escalation, by contrast, would likely see inflation recede quickly as oil prices normalize, potentially opening the door for rate cuts in the fourth quarter.

This article is for informational purposes only and does not constitute investment advice.