The U.S. economy remained resilient early this year, with a strong job market supporting solid consumer spending. The problem is that inflation has also been resilient.
The Commerce Department said Thursday that inflation-adjusted gross domestic product (GDP) grew at an annual rate of 1.6% in the first three months of this year. This is a sharp decline from the 3.4% growth rate at the end of 2023 and was well below forecasters’ expectations.
Economists expressed little concern about the economic slowdown, mainly due to large changes in business inventories and international trade, factors that fluctuate widely from quarter to quarter. Indicators of underlying demand have strengthened significantly, and there are no signs of the recession that forecasters spent much of last year warning about.
“Growth will be moderate to some extent, but it still signals a solid economy,” said Michael Gapen, chief U.S. economist at Bank of America. He said the report shows “few signs of weakness across the board.”
However, the solid growth numbers were accompanied by an unexpectedly rapid acceleration in inflation. Consumer prices rose at an annual rate of 3.4% in the first quarter, up from 1.8% in the final quarter of last year. Excluding the volatile food and energy categories, prices rose at an annualized rate of 3.7%.
Taken together, the first quarter’s statistics show that the Fed’s efforts to rein in inflation have stalled, and that financial markets’ celebrations of the economy’s apparent “soft landing” and gradual slowdown were premature. This is the latest evidence that this is the case.
“It increases the likelihood of a difficult landing,” said Constance L. Hunter, an economist at forecasting firm MacroPolicy Perspectives. “The inflation statistics were a surprise.”
At the very least, stubborn inflation will likely mean the Fed will wait until at least the fall to begin cutting rates. Some forecasters believe policymakers may actually raise rates further, rather than just keeping them there “for an extended period of time” as investors have been predicting for weeks. ing.
“This is a big change because a sudden ‘secular rise’ could mean further rate hikes,” said Diane Swonk, chief economist at KPMG. For now, he said, the Fed is stuck in “monetary policy purgatory.”
Financial markets fell on the news. The S&P 500 Index was down about 1% as of midday, and Treasury yields rose as investors expected borrowing costs to remain high.
Investors are not the only ones who will suffer if interest rates remain high. There are increasing signs that high borrowing costs are straining Americans’ economic well-being. Consumers saved just 3.6% of their after-tax income in the first quarter, down from 4% at the end of last year and more than 5% before the pandemic.
The signs of strain are particularly acute for low-income households. They are increasingly turning to credit cards to cover their expenses, and high interest rates are causing more people to default on their payments.
“There’s a sense now that low-income households’ budgets are becoming increasingly tight,” said Andrew Husby, senior U.S. economist at BNP Paribas.
However, despite these tensions, overall consumer spending shows little sign of slowing down. Spending grew at an annualized rate of 2.5% in the first quarter, but only slightly slower than in the second half of 2023, with spending on services such as travel and entertainment actually accelerating.
Spending has been driven by particularly wealthy consumers, who have been insulated from rising interest rates thanks to low debt and fixed-rate mortgages and benefited from record-setting stock markets until recently. .
“High-income households feel very flush,” said Brian Rose, senior economist at UBS. “They have seen their home values and portfolio values increase significantly and feel safe to continue spending.”
This presents a challenge for Fed policymakers. High interest rates, the main tool to fight inflation, hurt poorer households and do little to rein in spending for the wealthy. But if interest rates are cut, inflation could rise again.
Still, forecasters said the overall economic picture remains surprisingly rosy, especially compared to pessimistic forecasts from a year ago. Unemployment remained low, job growth remained strong and wages continued to rise, all of which resulted in after-tax incomes exceeding inflation in the first quarter.
Businesses ramped up investment in equipment and software in the first quarter, a vote of confidence in the economy. The housing market also recovered, in part because the decline in mortgage rates has since reversed.
The widening trade deficit, one of the drags on growth in the first quarter, was also largely a reflection of demand from the United States. Imports rose as Americans bought more goods from abroad, but exports rose more slowly.