KEY DATA: GDP: 2.3%; Consumption: +1.1%; Consumer Prices (Quarterly): +2.7%; Over-Year: +1.8%/ ECI (Over-Year): +2.7%; Wages: +2.7%/ Sentiment: -2.6 points

IN A NUTSHELL: “The acceleration in growth from the tax cuts has yet to kick in, but it does look like inflation is rising.”

WHAT IT MEANS: Tax cuts and government spending increases should lead to better overall economic activity, but that was not the case in the first quarter of the year. The economy expanded at a moderate pace that was well below the 2.9% rate posted in the fourth quarter of last year or the 3.3% rate in the third quarter. Solid business investment and a narrowing trade deficit were offset somewhat by soft consumer and government spending. Additions to inventory added to growth and that may be a sign that firms expect conditions to improve going forward. But for me, the story in this report was not the economy: It was inflation. Consumer prices rose sharply in the first quarter and even if you take out food and energy, the increase was still very high. Even though the gain from a year ago has yet to hit the Fed’s target of 2%, another quarter of high price increases similar to that posted in the first quarter will get us there.

Adding to my concern about inflation was the report on first quarter employment costs. The increase over the year was the highest in nearly a decade for both the overall index and for wages and salaries. Of real concern is that the private sector costs are growing faster than the public sector, which means that firms are facing even greater accelerating labor cost pressures.

Consumers were a little less optimistic in April than they had been. The University of Michigan’s Consumer Sentiment Index faded, led by a sharp decline in the perceptions of current conditions. Expectations remained solid, though they have stopped rising. The report indicated that the level of the index was consistent with a 2.7% increase in consumption over the next year. Given the tax cuts, that would be disappointing.

MARKETS AND FED POLICY IMPLICATIONS: Growth decelerated for the second consecutive quarter, not usually a sign of an economy picking up steam. But it was unreasonable to expect the impacts of the tax cuts to show up immediately. Businesses will invest more, though it is not clear how much more, and household spending will improve. But the decelerating growth pattern and the softening in optimism creates doubts about the ability of the economy to post the large gains many used to defend the passage of such a large tax cut. That said, there are questions about the first quarter seasonal adjustments, as the growth rates tend to be the lowest of the year. This was just the initial estimate, which will likely change. So don’t give up hope just yet. If as expected, growth does accelerate from the first quarter moderation, it is likely that inflation will follow suit. By the end of the current quarter, consumer price gains, using almost any index, will likely hit or exceed the Fed’s 2% target. Accelerating inflation would support rate hikes for the rest of the year and sustain the upward trend in market interest rates. No good economy goes unpunished and higher wage and price inflation and increasing interest rates are likely to be with us for quite a while. The earnings vs. interest rate battle is on.