Updated from 10:09 a.m. EDTHigher-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.
Gary Thayer, chief economist at A.G. Edwards, said the market "had begun to think that the Fed would raise rates in a surprising move either in May or June," but today's numbers suggest that won't happen. "They're still going to need a longer string of consistently strong numbers before they move," he said. Steven Wieting, senior economist at Smith Barney, believes first-quarter GDP will be revised higher going forward, noting that the inventory contribution in the quarter was lower than implied by other available data. "It seems a bit more likely than not that first-quarter GDP data will be revised higher," he said. Bill Cheney, chief economist at John Hancock Financial Services, agrees, saying it is "entirely possible ... that we'll see the inventories number revised upward, bringing everything more in line with expectations." Cheney isn't concerned about an immediate change to Fed policy because he said inflation has largely been driven up by higher energy costs. "With all the spare capacity and unemployed people in the U.S., it's hard to believe inflation poses anything close to a real threat right now," he said. Still, he added that "if these numbers are borne out as a new trend,
Fed officials will need to act more quickly and more aggressively than they anticipated." The central bank convenes next Tuesday and is widely expected to keep rates on hold. However, it is expected to lay the groundwork for a future rate hike. Contributing most to GDP last quarter was spending from consumers, businesses and the government. Increases in exports and private inventory investment also helped out, according to the Commerce Department. Consumer spending, which accounts for two-thirds of economic activity, grew by 3.8% in the quarter, after a 3.2% rise in the previous three months, as tax cuts and lower interest rates put more money into consumers' pockets.
Business spending rose 7.2% with spending on equipment and software up 11.5%. Exports of goods and services increased by 3.2%. Government spending rose 2% with federal spending up 10.1% and national defense spending up by 15.1%. In other news, the employment cost index jumped 1.1% in the first quarter, the most in a year, as benefit costs surged 2.4% and wages rose a moderate 0.6%. "Taken at face value, the gain in the ECI coupled with the less-robust-than-expected gain in GDP suggests that unit labor costs stopped falling in the first quarter," said Wieting. Weak unit labor costs have held inflation down so far. Fed Chief Alan Greenspan said in a recent speech that although labor costs have stopped falling, they "have yet to post a decisive upturn." Meanwhile, weekly jobless claims fell 18,000 in the latest week to 338,000. It was the steepest decline since a 28,000 drop in the week of Feb. 14. The four-week moving average, which smoothes out weekly fluctuations, fell 1,250 to 346,500.