Strong second quarter growth sparks rate hike talk

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A stunning acceleration in second quarter growth and a jump in inflation triggered a new round of speculation that the Fed will have to speed up plans to hike rates.

The faster pace of growth makes it more likely the economy will grow at a better clip in the second half, but strategists do not expect the Fed to change its timeline unless there is a consistent jump in activity. The number is not expected to have any impact on the Fed statement scheduled for 2 p.m. EDT Wednesday.

Second quarter GDP grew at 4 percent, well above the expected 3 percent. Traders focused on the faster pace of inflation at 2.3 percent annual rate, compared with 1.4 percent in the first quarter, as measured by the personal consumption expenditures index.

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“There has been a lot of chatter about the Fed being behind the curve. I think it’s going to be important to see what we get … in the inflation numbers and wage numbers” this week, said Michael Feroli, chief economist at JPMorgan.

Stocks rose and bond yields climbed, but stocks later gave up gains while bond yields held higher. The 10-year yield was at 2.51 percent in morning trading, well above the 2.46 percent level just before the release of GDP.

Yields were higher across the curve, with the 3-year above 1 percent, a level it has not consistently held since 2011. The 2-year yield reached 0.579 percent, the highest since May 2011. The short end of the curve is where much of the rate hike speculation has showed up.

The improvements to the economy in the GDP report were broad, with strengthening in government, business and the consumer. Consumer spending added 2.5 percent, better than the 1.9 percent expected.

“This market wants to read something bearish into it,” said David Ader, chief Treasury strategist at CRT Capital. Bad news, or bearish news for bonds is often good news for the economy.

Feroli said the pace of growth in the second half could be about 2.5 percent, and that there should be some giveback from the second quarter’s build in inventories.

Read More Why the Fed could raise rates sooner than you think

The number also shows a big bounce from the revised negative 2.1 percent first quarter.

“That big contribution from inventories being accumulated at over a $90 billion pace in the second quarter will weigh on, I think somewhat on activity in the third quarter,” Feroli said on CNBC’s “Squawk Box.” While looking back I think this is a better-than- expected picture for the first half as a whole, looking forward it may be a bit of a headwind in terms of businesses having to destock after having accumulated so many inventories in the second quarter.”

The last time GDP was above a 4 percent growth rate was third quarter of last year, when it was 4.5 percent. GDP for 2013 was revised higher to 3.1 percent, from 2.6 percent.

“The Fed has to be delighted with this. This also explains there had been a significant disconnect between an obviously improving labor market and growth measures, which had remained frustratingly low,” said Ward McCarthy, chief financial economist at Jefferies. “I think what we’re finding is the disconnect wasn’t really as acute as prior data had made it appear,”

The Fed is watching both inflation and the labor market as it weighs when it will further reduce stimulus by cutting rates. It is expected to finish tapering its bond buying program in October, and the market has been full of talk the Fed will move to cut rates sooner than the mid-2015 timetable that many economists expect.

But McCarthy said the Fed will not be swayed by the improving picture. “They’re looking for sustained growth, and this follows a pretty dismal first quarter,” he said. “This makes me much more confident the last two quarters of 2014 growth is going to average 3 percent or more.”

Joseph LaVorgna, Deutsche Bank’s chief U.S. economist, was the highest on the Street with his forecast of 4.2 percent second quarter growth, and he sees a strong 3.5 percent pace in the second half.

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He said the pickup in inflation is not surprising, but the Fed is not likely to move any faster to hike rates.

“Tightening sooner means they have to tighten less,” he said.

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