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April 30, 2025

Real GDP contracted at a 0.3% annualized rate in the first quarter after rising 2.4% in the fourth quarter. Attempts to front-run tariffs helped support consumer spending, investment and stockpiling of inventories. Surging imports subtracted five percentage points from overall growth. Exports increased only modestly after contracting in the fourth quarter.

Separately, the GDP deflator and the PCE price index both accelerated unexpectedly during the first quarter. These two inflation measures rose 3.7% and 3.6%, respectively. That compares to 2.3% and 2.4% in the fourth quarter; those gains further suppressed inflation-adjusted growth over the quarter.

Consumers hunker down

Consumer spending rose 1.8%, less than the 4.2% annualized surge of the fourth quarter. Spending on big-ticket items fell despite a late-in-quarter surge in vehicles sales to front-run tariffs. Nondurable goods and services held up better, helped by a big increase in spending on utilities; we had unusually cold January and February weather, which boosted utilities.

Consumer attitudes plummeted during the quarter on fears of inflation as job security faded. The drop in the University of Michigan’s index of consumer sentiment between February and April represented the largest three-month drop since the onset of the first Gulf War and the 1990 recession.

The Conference Board’s consumer confidence survey plummeted by more than 20 points over the last three months. Historically, such a large decline has preceded a recession. The only time that was not the case was in 2022 with the pandemic-induced inflation surge, Russia’s invasion of Ukraine, a banking crisis and the Federal Reserve’s decision to raise rates.  

Financial market volatility soared, which whittled away wealth effects. Those shifts could dampen spending going forward. Even if all the tariffs invoked since April 2 were revoked, we would still be dealing with the highest tariffs since the end of WWII.

Housing freezes

Home buying and building eked out a small 1.3% gain after rising 5.5% in the fourth quarter.  First-time home buyers returned in response to a brief dip in mortgage rates and a sweetening of incentives by builders.

Those shifts were not enough to boost housing affordability, which remains stubbornly low. The sheer level of prices � many new starter homes are priced at $1 million or above - is one of the largest hurdles. Higher interest rates, escalating real estate taxes and insurance costs are other obstacles.

Home builders are among the businesses that are the most sensitive to shifts in both tariffs and immigration policy. Their costs are already rising, which along with a drop in foot traffic has dampened builder sentiment. Consolidation, notably among single-family home builders, is expected to accelerate.

Businesses catch up

Business investment rebounded by 9.8%, after falling 3.0% in the fourth quarter. Much of that reflects a catch-up in aircraft deliveries, which were delayed by a strike in the aerospace sector.  Spending on information processing equipment soared at a stunning 69.3% rate. Electronics are in the crosshairs of tariffs.  

Inventories ballooned by $140 billion in annualized 2017 dollars, contributing 2.3 percentage points to overall growth. That is the largest increase since early 2022 when firms were still restocking due to the pandemic. Much of this gain resulted from stockpiling imports. Trade from China has since come to a virtual standstill.

Government spending contracted

Government spending dropped at a 1.5% pace, dragged lower by a 5.1% contraction in federal government expenditures on goods and services. State and local expenditures on goods and services rose at a slight 0.8% pace.

Federal spending fell a sharp 5.1% at an annual rate as defense expenditures plunged at an 8% pace and nondefense expenditures dropped at a 1% rate. These categories are volatile; the drops followed a period of above-trend gains but it is likely that newly implemented reductions in force and other cuts in spending are at least partially responsible for the decline. 

Growth in spending by state and local governments cooled to a 0.8% pace, the slowest since declines in spending in early 2022 on the backside of the Covid-related surge. Projects funded in the wake of the pandemic are finishing up. A shortfall in fiscal 2024 revenues and threats to federal funding suggest that spending by state and local governments could slip into the red as the year progresses.

Trade deficit widened sharply

Imports surged at a stunning 41.1% annual rate, buoyed by a 50.9% jump in goods imports. That is the fastest pace since the economy reopened in the wake of the pandemic in 2020. Exports edged up 1.8%, reversing a slight decline in the fourth quarter. The trade deficit measured in 2017 dollars widened by $322 billion, the largest quarterly increase on record. The only quarter that came close was the third quarter of 2020, which was half as large.

Hopes for a de-escalation of the trade war, notably with China, have emerged, but not materialized. China argued that it would need to see a unilateral drop in tariffs by the US to enter negotiations. As of yesterday, the Treasury Secretary argued that it was up to China to make the first move.

Inflation sticks

The data for personal income and consumption expenditures for March was released just after the GDP data. It usually comes out a day after the GDP release, although the information is already incorporated in the GDP report.

The personal consumption expenditure (PCE) index, the Federal Reserve’s favored inflation measure, moved sideways in March. That helped to bring the year-over-year measure of the PCE down to 2.3%, its slowest annual pace since October 2024. That is just after the Fed started to cut rates.

The core PCE, which excludes the important but volatile food and energy components, was also flat in March. That translates to a 2.6% year-over-year gain, its lowest level since June 2024.

A challenge for the Fed showed up in upward revisions in the January and February numbers. That data suggest that inflation was stickier ahead of tariffs than previously thought. That is before we see the effects of tariffs kick in; they are expected to be a larger problem in May than April as they will include a surge in tariffs and a near cessation of imports from China.

Policy purgatory for the Fed

In response, the Fed is expected to remain on the sidelines for much of this year. The recent drop in the value of the dollar on international exchange markets is another hurdle as it will amplify the boost to inflation by tariffs and could set the stage for a second bout of inflation if it persists.  

Why wait if the economy is weakening? Inflation remains somewhat elevated, while tariffs and a weak dollar are likely to boost prices further. History is littered with central banks that cut too soon to stimulate under such circumstances only to trigger a more pernicious bout of inflation or worse, stagflation. That history is seared into the Fed’s institutional memory.