Inflation Still Looms in Muted GDP

Updated from 10:09 a.m. EDT

Higher-than-expected inflation led to lower-than-expected economic growth in the first quarter, suggesting that time may be running out for the Federal Reserve to raise interest rates.

Gross domestic product rose 4.2% in the last three months, undershooting expectations for more rapid growth of 5%. But GDP came in above 4% for a third straight quarter, something that hasn't happened in 10 years. And pundits said economic growth would have been stronger had it not been for a larger-than-anticipated uptick in prices.

The GDP deflator rose 2.5% in the first quarter, up from a 1.5% increase in the prior quarter and higher than the 2% increase expected by economists. The Federal Reserve's preferred measure of inflation, the personal consumption expenditure price index, rose 3.2% after a 1% rise in the fourth quarter, while the core PCE index rose 2% compared to 1.2%.

"If you take out the unexpected inflation impact you would have gotten GDP around 4.7%, which is very close to expectations," said Drew Matus, economist at Lehman Brothers. "Really, this is an inflation story."

Matus said some economists had also been expecting a higher buildup of inventories in the quarter. Inventories added just 0.3 percentage points to growth.

"We're going back to more normal inflation," said Ron Napier, head of Napier Investment Advisors. "Greenspan, last week, told us that he's moved his bias away from deflation and in fact he's getting worried about inflation. A fed funds rate of 1%, which is abnormally low, is not going to hold much longer."

Napier said he is expecting a series of hikes this year, with the fed funds rate reaching 2% by year-end. Most analysts are predicting that the Fed will start to raise interest rates in August.

Despite the higher inflation numbers, investors seemed to focus on weaker growth Tuesday. Bonds rose while the dollar declined. Stocks were mixed, with the Dow up 9 points to 10,351 and the Nasdaq down 9 points to 1980.