GDP stumble will keep Fed guessing

Janet Yellen
Andrew Harrer | Bloomberg | Getty Images
Janet Yellen

With the U.S. job market on the mend and inflation perking up, Federal Reserve officials have said that a stronger economy means it's time to nudge interest rates higher.

Unfortunately, the latest read on the overall economy isn't cooperating with that scenario.

The government reported Thursday that U.S. gross domestic product, the broadest measure of economic growth, slowed to a crawl in the first three months of the year, expanding at an annual rate of just half a percent. Economists polled by Reuters had expected to see first-quarter growth come in at a 0.7 percent annual rate, after expanding at a 1.4 percent pace in the last three months of 2015.

Growth was dragged down by a range of forces, from slower spending by consumers and state and local governments to a cutback in businesses investing in new equipment. Much of that equipment spending shortfall came from the oil patch, where last year's plunge in crude prices forced a major contraction in new drilling.

It was the fastest slowdown in business outlays since the second quarter of 2009, at the bottom of the Great Recession.

Sluggish business spending may continue to hold back overall growth later this year, according to Paul Ashworth, an economist at Capital Economics.

"With corporate profits in decline, we don't anticipate any major turnaround in equipment investment for quite a while," he said in a note to clients Thursday.

With sales growth slowing, businesses also continued to cut back on inventories to avoid getting stuck with excess merchandise.

A strong dollar also cut into exports, which fell by 2.6 percent.

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There were some signs of strength, including a surge in spending on new homebuilding, as the U.S. housing market continues its gradual recovery. Investment in residential structures jumped nearly 15 percent.

And while spending weakened, separate reports show that employers continued to add to payrolls at a healthy clip.

Despite a recent uptick in the unemployment rate — largely the results of more job seekers entering or returning to the workforce — the labor market is holding up well, based on the number of people signing up for unemployment insurance. The latest weekly numbers show the level of new claims for jobless benefits has fallen to the lowest level since 1973.

Fed officials may also draw some encouragement from signs that inflation is finally picking up again. Thursday's report estimated that the core PCE rate was running at 2.1 percent on an annual basis in the first quarter.

Central bankers around the world have been slashing interest rates to zero — and below — to try to offset weakness brought by a long-term decline in commodity prices. So signs that prices are inching back up again could give Fed officials more leeway in nudging rates higher.

Still, some Fed watchers think the economy's weak first-quarter performance will likely slow the upward move in rates. At their latest regular meeting this week, U.S. central bank officials left rates alone, noting that "growth in economic activity appears to have slowed" and that "household spending has moderated."

But economist Joel Naroff noted that Fed officials were mum on where they see the economy headed later this year.

"That failure to discuss where the economy might likely go is another indication that the members are uncertain where the economy might go," he said in a note. "And uncertainty about how strong the economy might be going forward doesn't breed rate hikes."

Most forecasters expect the economy to perk up later this year. But it's far from clear whether that growth will match last year's average pace of 2.4 percent.

In its latest forecast, the Fed is looking for GDP to expand by 2.2 percent in 2016, a bit lower than it's 2.4 percent prediction in December.

Reports like Thursday's GDP data, though, make it less likely this year's overall growth will match that rate, according to Gregory Daco, head of U.S. macroeconomics at Oxford Economics.

"In light of our reserved growth and inflation profile, we expect a generally cautious Fed to hold off on raising rates until September," he said.