Inventories Weigh on First Quarter Growth

April 27, 2023

Gross domestic product expanded at a 1.1 percent annualized pace in the first quarter of the year. This was slower than the 2.6 percent pace of growth in the final quarter of last year and below the 1.9 percent growth expected by economists. Though growth was slower than the estimated potential growth rate of the economy, we do not expect this morning’s data will keep the Federal Reserve from increasing interest rates by 25 basis points early next month. While there were signs in the data that the Fed’s cumulative interest rate increases to date are negatively impacting output, consumers seem undeterred, and the underlying growth trend in the economy is solid.

Annualized growth in consumer spending accelerated to 3.7 percent, the fastest since the second quarter of 2021. Spending on services increased by 2.3 percent, but the 6.5 percent growth in spending on goods was one of the bigger surprises in the report. This was the first quarter where goods spending expanded in over a year. Moreover, spending on durable goods accounted for more than half of consumption’s contribution to overall growth. Durable goods are more exposed to interest rates, and we expected the category would suffer in the prevailing high-rate environment. Instead, it seems that pent-up demand (particularly for motor vehicles) and strong income growth offset the impact of higher interest rates.

However, other categories are showing the impact of higher rates. As interest rates increase and lending standards become more restrictive, the bar for capital projects to be economically feasible gets higher. That dynamic played out in the first quarter. Nonresidential fixed investment growth slowed to just 0.7 percent after expanding at a 6.2 percent and 4.0 percent annualized pace in the third and fourth quarters, respectively. Business spending on equipment fell an annualized 7.3 percent, the second consecutive quarterly decline and the biggest since the second quarter of 2020. Elsewhere, residential fixed investment fell for the eighth consecutive quarter, reflecting the poor housing affordability environment brought on by the sharp increase in mortgage rates we’ve seen over the last year.

Though consumer spending withstood the pressure from pressure coming from the interest rate environment, businesses seem to be preparing for a weaker demand environment later this year. Inflation-adjusted private inventories fell by an annualized $1.6 billion, marking the first contraction in inventories in six quarters. Though this is a small decline within an economy generating more than $26 trillion in nominal GDP, because it reversed a trend of expanding inventories, it had a significant negative impact, subtracting 2.26 percentage points from overall growth.

Inventories are historically a volatile category, and they have been particularly so since the pandemic disrupted global supply chains. That’s one reason why it’s still wise to look at subsets of GDP that exclude categories that may obscure the core growth of the economy. We prefer a measure called final sales to private domestic purchasers, which includes just consumer spending and business fixed investment. Together these categories account for nearly 90 percent of GDP. This subset grew by an annualized 2.9 percent in the first quarter after being flat in the fourth quarter.

This suggests that the underlying core growth in the economy improved in the first three months of the year despite the high-interest rate environment. We expect that will permit the Federal Reserve to increase interest rates by 25 basis points at its next meeting in May. However, we still expect the economy can weaken later this year as the cumulative impact of the Fed’s rate increases weighs on consumers and businesses. We do not anticipate the strength in durable goods spending we saw in the first quarter will continue in the coming quarters, and material improvement in business fixed investment is unlikely. Our base case is still that the US economy could fall into a mild recession in the second half of the year.

David Allen, CFA, CFP

Chief Investment Officer

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