The U.S. economy remained resilient early this year, with a strong labor market driving solid consumer spending. The problem is that inflation also resisted.
Inflation-adjusted gross domestic product rose at an annual rate of 1.6 percent in the first three months of the year, the Commerce Department said Thursday. That figure was well below the 3.4 percent growth rate at the end of 2023 and was well below forecasters’ expectations.
Economists were largely unconcerned about the slowdown, which was mainly due to large changes in business inventories and international trade, components that often swing wildly from quarter to quarter. Measures of underlying demand were significantly stronger and offered no indication of the recession that forecasters spent much of last year warning was on the way.
“It would suggest some moderation in growth, but still a strong economy,” said Michael Gapen, chief U.S. economist at Bank of America. He said the report contained “few signs of weakness overall.”
But the strong growth figures were accompanied by an unexpectedly rapid acceleration in inflation. Consumer prices rose at an annual rate of 3.4 percent in the first quarter, up from 1.8 percent in the final quarter of last year. Excluding the volatile food and energy categories, prices rose at an annual rate of 3.7 percent.
Taken together, the first-quarter data was the latest evidence that the Federal Reserve’s efforts to control inflation have stalled and that celebration in financial markets for an apparent “soft landing” or mild slowdown in the economy It had been premature.
“It increases the chances of a harder landing,” said Constance L. Hunter, an economist at MacroPolicy Perspectives, a forecasting firm. “The inflation data was the surprise.”
At a minimum, persistent inflation likely means the Federal Reserve will wait until at least the fall to begin cutting interest rates. Some forecasters believe policymakers may not just keep rates “higher for longer,” as investors have been anticipating for several weeks, but could actually raise them further.
“It’s a huge change because suddenly ‘higher for longer’ could mean another increase,” said Diane Swonk, chief economist at KPMG. For now, she said, the Federal Reserve is trapped in “monetary policy purgatory.”
Financial markets fell on the news. The S&P 500 index ended the day down about half a percentage point and government bond yields rose as investors anticipated borrowing costs would remain high.
Investors aren’t the only ones who could be affected if interest rates remain high. There are growing signs that high borrowing costs are weighing on Americans’ financial well-being. Consumers saved just 3.6 percent of their after-tax income in the first quarter, down from 4 percent at the end of last year and more than 5 percent before the pandemic.
Signs of strain are particularly acute for low-income households. They have increasingly turned to credit cards to meet their expenses, and with high interest rates, many of them are falling behind on their payments.
“There’s a sense that lower-end households are becoming more squeezed right now,” said Andrew Husby, senior U.S. economist at BNP Paribas.
Yet despite those tensions, consumer spending as a whole shows little sign of cooling. Spending rose at an annual rate of 2.5 percent in the first quarter, only slightly slower than at the end of 2023, and spending on services such as travel and entertainment actually accelerated.
Spending has been driven particularly by wealthier consumers, whose low debt and fixed-rate mortgages have insulated them from the effects of higher interest rates, and who have benefited from a stock market that until recently was setting records. .
“Households with higher incomes feel very satisfied,” said Brian Rose, senior economist at UBS. “They’ve seen such a big increase in the value of their home and the value of their portfolios that they feel like they can keep spending.”
This presents a conundrum for Federal Reserve policymakers: Their main inflation-fighting tool, high rates, is doing little to curb spending by the rich while hurting poorer households. And yet, if they reduce those rates, inflation could accelerate again.
Still, forecasters said the overall economic outlook remains surprisingly optimistic, especially compared to the gloomy predictions from a year ago. Unemployment has remained low, job growth has remained strong and wages have continued to rise, all of which helped after-tax income outperform inflation in the first quarter.
Companies increased their investment in equipment and software in the first quarter, a vote of confidence in the economy. The housing market also recovered, although that was partly due to a drop in mortgage rates that has since reversed.
Even one of the brakes on growth in the first quarter – a growing trade deficit – mainly reflected demand from the United States. Imports rose as Americans bought more goods from abroad, while exports rose more modestly.
