U.S. Growth Was Positive in the First Quarter—But Don't Break Out the Champagne

Our expectation in early April had been that GDP would contract by 0.1%. But given the new evidence available since then, we were looking for a 0.8% growth rate going into today's report. The key change in our view over the month was that inventories would rise instead of fall, and that did prove to be the key difference between the 0.6% outcome and our original -0.1% expectation.

The bad news in today's report was that the most cyclically sensitive categories of domestic final demand all declined. Consumer spending on both durable and nondurable goods fell, the first time they have declined together since the 2001 recession. Residential investment continued to plunge, with the latest (26.7%) decline being the biggest so far in this downturn. Worse still, nonresidential structures spending also fell—its first drop in 10 quarters—while business equipment spending was also down, albeit slightly.

Final sales declined (by 0.2%), but overall growth stayed positive because businesses added slightly to their inventories after running them down in the fourth quarter. Some of that accumulation is probably unwanted. Apart from inventories, support came from consumer spending on services, government spending, and exports.

We think it is likely that GDP will decline in the second quarter. Inventory accumulation should turn negative again, while all investment categories should keep declining. And government spending growth will likely be softer.

The consumer is the wild card. All key drivers of consumer spending are pointing down—employment, real wages, home prices, and credit availability—but consumers are now receiving a temporary injection of spending power from the tax rebates. We suspect that these will kick in neither quickly nor strongly enough to keep second-quarter GDP growth positive, but the third quarter should show growth of 2.0–2.5%.

On the inflation front, the overall GDP price index rose 2.6%, slightly faster than in the fourth quarter. For consumers, the key inflation indicator is the personal consumption price index, which advanced a strong 3.5%, and it is of small comfort that the rise was less than the 3.9% increase in the fourth quarter. The key measure watched most closely by the Federal Reserve—the personal consumption price index excluding food and energy—was up 2.2% at an annual rate, just outside the 1–2% comfort zone. But at this point, with food and energy prices climbing rapidly, the Fed is becoming increasingly concerned that continuing rapid rises in the overall consumption price index will cause inflation expectations to become unhinged.

Looking at an economy showing most hallmarks of recession, but not yet contracting in GDP terms, and beset by inflationary pressures on key commodity prices, the Fed made a small rate cut today (25 basis points) and give a hint (not a promise) of a rate-cut pause. The big danger is that once the tax rebate effect wears off, the economy stalls again. So, the Fed has left the door open for future action if the rebate stimulus is overwhelmed by the underlying drag from the credit markets, housing, and a fundamentally unhealthy consumer.

The slight positive result for real GDP will no doubt spark a (we believe, unproductive) debate about whether the economy is actually in recession or not. We have stated that we believe that the economy is in at least a mild recession, and the first-quarter GDP evidence on its own is insufficient to make us change that call. The simplistic recession definition (two negative quarters of GDP in a row) will not decide the issue. The National Bureau of Economic Research also looks at a broader range of monthly indicators when making its call (employment, real income, industrial production, and wholesale and retail sales). We anticipate that when all the data are in, the weakness in these indicators during the first half of the year will be sufficient to warrant the description "recession." But whether or not this episode qualifies as a "technical" recession, the important point is that the U.S. economy is in for an extended period of weakness.