The US economy contracted unexpectedly in the first quarter on a resurgence in COVID-19 cases and a fall in government aid to the pandemic, but the fall in output is misleading as domestic demand remained strong.
The first contraction in gross domestic product in almost two years, reported by the Commerce Department on Thursday, was mainly due to a wider trade deficit as imports surged and a slowdown in inventory building from the fourth quarter’s robust pace.
A measure of domestic demand accelerated from the fourth quarter, allaying fears of stagflation or a recession. The US Federal Reserve is expected to hike interest rates by 50 basis points next Wednesday. The US Federal Reserve raised interest rates by 25 basis points in March and is expected to start trimming its holdings soon.
“The economy is still showing some resilience, but the Q1 GDP report signals the start of more moderate growth this year and next, mainly in response to higher interest rates,” said Sal Guatieri, senior economist at BMO Capital Markets in Toronto. “Despite the contraction, the Fed has little choice but to hike aggressively in May to curb inflation.”
Gross domestic product fell an annualized 1.4% in the most recent quarter, the government said in its GDP advance estimate. The economy grew at a robust pace of 6.9% in the fourth quarter. Economists polled by Reuters forecast economic growth of 1.1%. Estimates ranged from a contraction rate of just 1.4% to a growth rate of 2.6%.
In the last quarter, the economy was also hit by supply chain challenges, labor shortages and rampant inflation. Nevertheless, production in the fourth quarter of 2019 remains 2.8% above its level. Year-on-year, the economy grew 3.6% in the first quarter.
Imports skyrocketed, in part due to upfront spending by companies fearing shortages from the Russia-Ukraine war. At the same time, exports collapsed. This led to a sharp widening of the trade deficit, which deducted 3.2 percentage points from GDP growth. Trade has now held back growth for seven consecutive quarters.
Businesses have turned to imports to meet demand, with local manufacturers unable to boost production. Although companies continued to build inventories, the pace slowed from the fourth quarter, leading to inventory investment dragging 0.84 percentage points off GDP growth.
US stocks opened higher. The dollar rose against a basket of currencies. US Treasury prices were mixed.
Consumer spending growth, which accounts for more than two-thirds of U.S. economic activity, rose to 2.7% from 2.5% in the fourth quarter, despite being hit by the winter wave of coronavirus cases fueled by the Omicron variant . Even with food and gas prices soaring, there are still no signs that consumers are retreating.
Strong wage increases amid a tight labor market and at least $2 trillion in excess savings accumulated during the pandemic are providing a cushion against inflation. According to data from Bank of America Securities, low-income consumers, who tend to be disproportionately hit by inflation, have shown more resilience.
The strengthening in labor market conditions was bolstered by a separate Labor Department report on Thursday showing initial jobless claims fell by 5,000 to a seasonally adjusted 180,000 in the week ended April 23.
Economists had forecast 180,000 applications for the past week. Business investment accelerated, with equipment spending rising 15.3% in the most recent quarter.
This, combined with solid consumer spending, boosted final sales to private domestic buyers by 3.7%. This metric of domestic demand, which excludes trade, inventories and government spending, rose 2.7% in the fourth quarter. Final sales to private domestic buyers account for about 85% of total spending.
Still, concerns remain that the Fed could aggressively tighten monetary policy and push the economy into recession over the next 18 months. The housing market is already showing signs of slowing down, with 30-year fixed-rate mortgages shooting over 5%.
But much would depend on how quickly geopolitical tensions and supply chains ease, and whether inflation eases.