Worst of all worlds
GDP growth slows, but inflation remains elevated
Gross Domestic Product (GDP) rose by a weaker-than-expected 1.1% annualized rate in the first quarter, down sharply from 2.6% and 3.2% gains in the fourth and third quarters of 2022, respectively. This was roughly in line with our 1.3% estimate here at Federated Hermes. The Blue Chip consensus estimate was at 1.5%, the most recent Bloomberg consensus estimate was at 1.9% (down from 2.7% a fortnight ago) and the Atlanta Fed’s GDPNow model has fallen from 3.5% last month (and 2.5% two weeks ago) to an in-line 1.1%.
What happened? Personal consumption rose by a weaker-than-expected 3.7% in the first quarter (softer than consensus estimates at 4% growth), but that was consistent with month-over-month (m/m) retail-sales declines in both February and March. Importantly, companies liquidated inventories by $1.6 billion in the first quarter, down sharply from an unsustainable fourth-quarter inventory surge of $136.5 billion, which was more than triple the third quarter’s gain of $38.7 billion. This change in inventories reduced GDP by 2.26 percentage points. Corporate capex and net trade contributed modestly to first-quarter GDP, although residential construction was a drag for the eighth consecutive quarter. Finally, government spending surged, particularly for federal nondefense, adding 81 basis points to growth.
Private domestic final sales rebounded This is a much better metric to gauge the economy’s underlying fundamental strength because it excludes volatile inventory liquidation/restocking, net trade and government spending. It rose by a solid 2.9% in the first quarter, compared with breakeven in the fourth quarter of 2022 and a 1.1% increase in the third quarter. While we believe that the U.S. economy is not in a recession now, we still expect this metric to slow in coming quarters.
Inflation continues to grind lower The core Personal Consumption Expenditure (PCE) inflation index (the Federal Reserve’s preferred measure of inflation) slowed to an in-line 4.6% year-over-year (y/y) growth rate in March. That’s down from 4.7% in February and lower than its February 2022 peak at 5.4%, a 39-year high. In its Summary of Economic Projections last month, the Fed projected that core PCE will hit its 2.1% target by the end of 2025. So, inflation continues to slow gradually, but it will likely be more than two years before the Fed can confidently declare victory.
What will the Fed do next week? Given the combination of relatively solid economic growth and sticky inflation, we think the Fed will hike interest rates by another quarter point. That would raise the upper band of the fed funds range to 5.25%.
Yield curve still inverted The spread between 2- and 10-year Treasury yields is typically an excellent early-warning recession indicator. The curve has been inverted for more than a year and sits at a 60 basis-point difference now, with the 2-year yield at 4.05% and the 10-year at 3.45%.
Details on the first-quarter GDP report:
Personal consumption (70% of GDP) rose by a weaker-than-expected 3.7% in the first quarter (accounting for 2.48 percentage points of the gain in overall GDP) versus consensus expectations for a much stronger 4% increase. Regardless, this was still the strongest quarter-over-quarter (q/q) gain since the second quarter of 2021 (up 12.1%) and much stronger than recent gains of 1% and 2.3% in the fourth and third quarters of 2022, respectively. Spending on goods (up 6.5%) outstripped a 2.3% increase in services in the first quarter.
While nominal retail sales enjoyed a powerful 3.1% gain in January 2023, they declined by 0.2% and 1% in February and March, respectively. In fact, retail sales were negative in four of the past five months. Moreover, the personal savings rate has surged from a 17-year low of 2.7% in June 2022 to 5.1% in March 2023, which suggests consumers are building dry powder at the expense of spending, perhaps due to recession fears. Consequently, personal consumption could decline further in coming months.
Inventory restocking surged by $136.5 billion in the fourth quarter of 2022 on a chained-dollar basis, more than triple the third quarter’s $38.7 billion pace, which added 1.47 percentage points to GDP growth in last year’s fourth quarter. In our view, that pace of inventory restocking was unsustainable in a slowing economy; we expected a sharp reduction in the first quarter. As if on cue, inventories declined by $1.6 billion last quarter, and that dramatic q/q change of about $138 billion reduced growth by an outsized 2.26 points in the first quarter.
Residential construction fell 4.2% in the first quarter (which reduced GDP growth by 0.17 points), marking its eighth consecutive quarter of declines. But the fourth, third and second quarters fell by 25.1%, 27.1% and 17.8%, respectively. The housing recession is getting less bad. Mortgage rates more than doubled from 3% to 7.35% in 2022, new and existing home prices spiked 50% over the past two years to record highs, and affordability plummeted to its worst level since 1986. But there is still tremendous pent-up demand among potential home buyers. As mortgage rates and prices have eased in recent months, housing activity has improved.
Net trade added 11 basis points to growth in the first quarter. That's due to the relative first-quarter weakness in the dollar against the yen, pound and euro, which make U.S. exports cheaper. Exports rose 4.8% in the first quarter, boosting growth by 0.48 percentage points versus a decline of 3.7% in the fourth quarter and strong gains of 14.6% and 13.8% in the third and second quarters, respectively. Imports rose 2.9% in the first quarter, which subtracted 0.43 points from growth, compared with declines of 5.5% and 7.3% in the fourth and third quarters, respectively.
Corporate nonresidential capital spending rose by a modest 0.7% in the first quarter (adding 0.10 percentage points from GDP growth), versus stronger gains of 4% and 6.2% in the fourth and third quarters, respectively. After six consecutive quarterly declines, structures rose for the second consecutive quarter by 11.2% (adding 29 basis points to GDP), compared with a 15.8% fourth-quarter gain and a 3.6% decline in the third quarter. Equipment spending declined for the second consecutive quarter by 7.3% in the first quarter (subtracting 0.39 points), the largest decline since the second quarter of 2020, versus a 3.5% fourth-quarter decline and a strong 10.6% third-quarter gain. Intellectual property spending grew 3.8% for the ninth consecutive quarter (adding 20 basis points to GDP growth), compared with gains of 6.2% and 6.8% in the fourth and third quarters, respectively.
Government spending rose for the third consecutive quarter by 4.7% in the first quarter, adding 0.81 percentage points to growth, which snapped five consecutive negative quarters. Federal spending grew 7.8% in the first quarter (adding 0.49 points), paced by a sizable 10.3% increase in nondefense spending (adding 28 basis points). State and local spending rose 2.9% in the first quarter (adding 31 basis points), versus gains of 2.6% and 3.7% in the fourth and third quarters, respectively.