Why weak Q1 growth in U.S. shouldn’t be a surprise

The U.S. economy turned in the weakest performance in three years in the January-March quarter as consumers sharply slowed their spending. The result underscores the challenge facing President Donald Trump in achieving his ambitious economic growth targets.

The gross domestic product, the total output of goods and services, grew by just 0.7% in the first quarter following a gain of 2.1% in the fourth quarter, the Commerce Department reported Friday.

The slowdown primarily reflected slower consumer spending, which grew by just 0.3% after a 3.5% gain in the fourth quarter. It was the poorest showing in more than seven years.

Economists attributed the sharp slowdown in consumer spending to shrinking utility bills due to warmer weather, a drop-off in auto sales and a delay in sending out tax refund checks by the IRS, which also dampened spending.

Sal Guatieri, senior economist at BMO Capital Markets, said he expected consumer and government spending to bounce back, leading to a much stronger second quarter. “Still, the report will mark a rough start to the administration’s high hopes of achieving 3% or better growth, not the kind of news it was looking for to cap its first 100 days in office,” Guatieri said in a note to clients.

Averaging the two quarters, they forecast growth of around 2% for the first half of this year. That would be in line with the mediocre performance of the eight-year economic expansion, when growth has averaged just 2.1%, the poorest showing for any recovery in the post-World War II period.

Krishen Rangasamy, senior economist at National Bank, is optimistic nonetheless. In a report, Rangasamy says, “The U.S. economy is in better shape than what’s suggested by soft Q1 GDP data, [given that’s] partly reflecting residual seasonality. A sharp rebound over the coming quarters should allow 2017 GDP growth to accelerate to about 2.2%.”

Rangasamy adds, “While acknowledging risks such as trade policy and geopolitics, we expect a further acceleration for U.S. growth next year, thanks in part to tax cuts which Congressional Republicans have to pass to have any chance of retaining power after the 2018 mid-term elections.”

Indeed, Trump repeatedly attacked the weak GDP rates during the campaign as an example of the Obama administration’s failed economic policies. He said his program of tax cuts for individuals and businesses, deregulation and tougher enforcement of trade agreements would double growth to 4% or better.

In unveiling an outline of the administration’s tax proposals on Wednesday, Treasury Secretary Steven Mnuchin said he believed growth above 3% would be achievable.

Private economists are more skeptical: they’re forecasting growth this year of around 2.2%. That would be an improvement from last year’s 1.6%, the weakest showing in five years, but far below Trump’s goal. Many analysts believe that the impacts of Trump’s economic program will not be felt until 2018 because they are not expecting Congress to approve some version of Trump’s tax program until late this year.

In a separate release that looks at residual seasonality, Rangasamy says, “A slowdown was always in the cards after a strong second half of 2016, when annualized growth averaged 2.6%–well above potential. The inventory drawdown in Q1 also means growth will get a boost later from restocking.”

Rangasamy adds it’s encouraging that there’s been an “uptick in business investment spending after a disappointing 2016, a positive for the U.S. economy’s potential growth but also a reflection of growing confidence in the economic outlook.”

Business investment rose at a 9.4% rate, helped by a record surge in spending in the category that tracks spending in the energy sector. This category had seen sharp cutbacks in recent quarters, reflecting reductions in exploration and drilling as energy prices declined.

Q1 often weak. Why?

In recent years, the first quarter has often turned out to be the weakest for the year, reflecting in part problems the government has not been able to resolve in adjusting its figures for normal seasonal changes.

The Bureau of Economic Analysis, which prepares the GDP report, has a three-year program aimed at addressing this problem, which has been particularly problematic in the first quarter. Analysts say that lingering issues in this area may artificially hold down Friday’s initial GDP estimate for the first quarter.

Many economists believe growth in the current April-June quarter will rebound to a rate of 3% or better as consumer spending, which accounts for two-thirds of economic activity, regains momentum.

“There are a lot of tailwinds behind consumers going into the spring, including low unemployment, better wage growth, high consumer confidence and record stock prices,” said Mark Zandi, chief economist at Moody’s Analytics.

Job growth was strong in January and February before slowing in March, and the unemployment rate is at a nearly decade-low of 4.5%.

Trump noted the weak 2016 GDP performance in a tweet Wednesday and contended that “trade deficits hurt the economy very badly.” For the first quarter, trade was actually a small positive after a major drag in the fourth quarter.

Part of the problem for the administration is that its efforts to boost the economy are coming after the economic expansion has been underway for nearly eight years. At this point in a recovery, stimulus measures tend to have less impact. The Federal Reserve, in fact, has begun raising interest rates to ensure that the tight job market doesn’t trigger high inflation pressures.

For now, analysts say they think Trump’s stimulus efforts and the Fed’s gradual tightening can co-exist. Yet they also caution that the Fed may eventually raise rates to a point where they will begin to constrain growth, making it harder for Trump to achieve his GDP goals.

In a release, TD Economics senior economist Leslie Preston says, “In its decision next week, the Fed is unlikely to put too much stock in another Q1 GDP disappointment. It will likely be more concerned with the cooling in inflation seen in March,” and will stick with its “gradual pace of rate hikes.”

Preston is also positive on growth, noting, “Underlying growth in the U.S. economy to be running slightly better than 2%. With an aging population this is a decent pace of growth relative to the economy’s potential.”

RBC economist Josh Nye toes the same line, noting in a release, “We are far from ready to throw in the towel on our forecast for growth to pick up in 2017. In fact, the underlying details generally support our outlook for a more broadly-based increase in domestic spending to underpin above-trend activity this year.” He also expects little from the Fed next week.

Currently, CME’s FedWatch tool shows there’s nearly a 95% probability that the central bank will stand pat on rates.

Unemployment costs in Q1

Wages and benefits paid to U.S. civilian workers grew steadily in the first three months of the year.

The Employment Cost Index, which tracks wages and benefits, was up 0.8% in the first quarter, the Labor Department said Friday, That’s the biggest quarterly growth since December 2007 and slightly faster than the 0.5% growth in the last quarter of 2016.

Wages and salaries, which account for 70% of compensation costs, rose 0.8%. Benefit costs, which cover pensions and health insurance, increased 0.7%.

The index has shown steady improvement as the U.S. unemployment rate has fallen to 4.5%. The modest advance in the first quarter indicates that wage gains haven’t accelerated to a pace that would worry the Federal Reserve about inflation. A recent Fed report showed that overall wage increases remained modest, although businesses were being forced to offer bigger increases to workers with skills that are in short supply.

“Overall, moderate employment growth is finally starting to mean moderate compensation growth for employees, which is the raw material for personal income which, in turn, supports consumer spending,” said an analyst report from Contingent Macro Research.

That would be helpful in the months ahead for the overall economy, which grew a lacklustre 0.7% in the January-March quarter largely because consumers spent sharply less.

Compensation for state and local government workers grew 0.6%, matching the previous quarter’s gain. Among private sector workers, compensation grew 0.8%, compared to 0.5% in the fourth quarter.

In the past year, salaries and benefits for all civilian workers have risen 2.4%. That’s better than the 2.2% for last quarter, but below the roughly 3.5% generally considered consistent with a healthy economy.

For the 12 months ending in March 2016, wage and benefit growth was 1.9%.

Among private industry workers, those employed in sales, construction, aircraft manufacturing and retail showed the largest compensation increases.