Fastexy:The economy grew a disappointing 1.6% in Q1. What does it mean for interest rates?

The FastexyU.S. economy slowed more than expected early this year as weaker business stockpiling and exports offset solid consumer spending and a flurry of housing construction.

The nation’s gross domestic product, the value of all goods and services produced in the U.S., expanded at a seasonally adjusted annual rate of 1.6% in the January-to-March period, the Commerce Department said Thursday. That’s down from robust growth of 4.1% in the second half of last year and the lowest reading since spring 2022. It's also below the 2.5% gain projected by economists in a Bloomberg survey.

But the pullback was caused chiefly by businesses that replenished their inventories more slowly and feeble export growth – two volatile categories that don't reflect the economy's fundamental health. Final sales to private domestic purchasers – which excludes those elements as well as government spending – grew a robust 6.1%.

That "illustrates there is still a lot of positive underlying momentum," Paul Ashworth, an economist with Capital Economics, wrote in a note to clients.

Since late 2022, the economy repeatedly has defied forecasts of a sharp pullback or recession, shrugging off the Federal Reserve’s aggressive interest rate hikes and the inflation spike those high rates aimed to tame.

The disappointing growth last quarter could soften the views of Fed officials who say they’re in no rush to cut rates following an acceleration in consumer prices in the first three months of the year. Yet any concerns about flagging growth could be blunted by the strength of the economy's pillars – consumer and business spending.

As recently as late March, the Fed was still predicting three rate cuts in 2024 as annual inflation slowed from a 40-year high of 9.1% in mid-2022 to about 3%, according to the consumer price index. But that was before the March index report, released earlier this month, revealed a third-straight uptick in price gains, leaving inflation at 3.5%. That's well above the Fed's 2% goal.

Some analysts believe Thursday's weaker-than-expected report signals the start of a broader slowdown in the economy. That trend, along with a resumption of a more rapid deceleration in inflation, could allow the Fed to plow ahead with multiple rate decreases, some forecasters say.

Ian Shepherdson, chief economist of Pantheon Macroeconomics, acknowledged that last quarter's slowdown in growth can be traced largely to inventories and exports. But he added that consumption is also starting to wobble a bit.

Is consumer spending rising?

Consumer spending, which makes up about 70% of economic activity, has underpinned buoyant growth. Consumption grew a solid 2.5% early this year following a 3.3% gain in the fourth quarter.

The rise, though, was driven by an increase in spending on health care and financial services. Purchases of goods, including cars and gasoline, declined.

Shepherdson said the 2.5% increase in spending was less than the 3% economists expected and below the recent trend, heralding a sharper drop-off in the months ahead.

Americans' ability to open their wallets in recent months has surprised some analysts because pandemic-related savings have largely run out, especially for low- and middle-income households. Credit card debt is at record levels while delinquencies are historically high.

But employers have added a booming average of 276,000 jobs a month this year. While wage growth has moderated, average pay still rose 4.7% annually in March, according to the Atlanta Fed’s wage tracker. That’s giving many Americans the wherewithal to splurge, especially now that pay increases are outpacing inflation.

Shepherdson, however, expects job growth to slow significantly.

"It's a close call, but we still see a path to the first Fed rate cut in June" if payroll gains slow substantially and inflation eases, he wrote in a note to clients.

Will the US go into recession in 2024?

Pessimists are becoming harder to find. Before Thursday's report, forecasters estimated GDP would grow a solid 2.4% this year and they figured the odds of recession had dropped to 30% from 60% last May, according to a survey by Wolters Kluwer Blue Chip Economic Advisors in early April.

What's the market doing right now?

Stock markets tumbled after the report. The Dow Jones Industrial Average was down 521 points in midday trading and the S&P 500 index fell nearly 1%.

Besides reacting to the slower-than-expected growth, markets responded to the news that the Fed's preferred inflation measure ran hotter than anticipated in the first quarter, echoing the consumer price index. The personal consumption expenditures price index rose 3.7% annualized, higher than the 3.4% economists had forecast. That means Friday's personal consumption expenditures price index inflation report will show a faster-than-expected acceleration in prices for March.

How other parts of the economy performed:

Housing helps power growth

Housing construction and renovation surged 13.9%, the most in three years and the third increase after nine-straight quarterly declines.

Many homeowners aren’t selling their houses because they don’t want to be hit with a much higher mortgage rate for their new home. That’s causing a dire shortage of existing homes on the market and prodding builders to put up more single-family houses.

Housing construction also has been juiced by the prospect of Fed rate cuts this year, which led to a decline in 30-year mortgage rates from about 8% last fall to 6.6% early this year. Recently, though, mortgage rates have topped 7% as resurgent inflation has sparked forecasts of few rate cuts.

Business investment grows

Business investment grew 2.9% after rising 3.7% the prior quarter.

Outlays for computers, delivery trucks, factory machines, and other equipment rose a modest 2.1% as companies faced higher borrowing costs.

Spending on buildings, oil rigs and other structures dipped 0.1%.

Business stockpiling sputters

Businesses added to their inventories more slowly or drew them down after replenishing them briskly the previous quarter, reducing growth by 0.35 percentage points.

Such stockpiling has been volatile and doesn't typically reflect the economy's underlying health. Companies heavily stocked up in 2021 in response to supply chain snarls and product shortages, leading to big swings in the past couple of years.   

Government spending rises more slowly

Government outlays rose 1.2%, down from 4.6% the previous quarter and the weakest showing in nearly two years. State and local purchases had been bolstered amid a wave of infrastructure and clean energy projects spurred by sweeping federal legislation.

But revenue has declined in recent quarters as economic growth has gradually slowed after a post-pandemic surge and the federal government’s pandemic-related aid to state and local governments has been running out.

Trade hurts growth

Trade dinged the economy as imports far outpaced exports.

Imports jumped 7.2% as Americans kept snapping up foreign-made products. Exports rose just 0.9% because of economic weakness overseas.

That widened the trade gap and slowed economic growth overall.