By Martin Wolk Executive business editor
msnbc.com
updated 4/29/2004 5:35:29 PM ET 2004-04-29T21:35:29

Economic growth was slower than expected in the first quarter as inflation rose sharply, the government said Thursday in a report that could push the Federal Reserve a step closer to raising interest rates.

Major Market Indices

Most analysts said the economy remains on a solid growth path that should result in steadily rising employment this year, but some expressed concern that rising inflation will force the Fed’s hand. Fed chairman Alan Greenspan and other policy-makers meet next week and are likely to formally acknowledge the growing inflation risk, although they are not expected to raise short-term interest rates from current, historically low levels.

Gross domestic product grew at a solid 4.2 percent annual rate in the first quarter, about the same as the 4.1 percent pace in last year’s fourth quarter, the Bureau of Economic Analysis said. The figure was somewhat lower than the 5 percent many analysts had predicted, largely because inflation, at 2.5 percent, was higher than expected. GDP growth is adjusted for inflation, so higher inflation generally means slower real growth.

Still, the GDP report, the broadest measure of the economy’s overall health, reinforced expectations for good growth of 4 to 5 percent this year. And some analysts said the first-quarter figure could be revised upward as the government gets more data.

“Even though the number was a bit lower than consensus, the economy has shown more balanced growth,” Wells Fargo chief economist Sung Won Sohn said in a note. “The economy has settled into a sustainable, self-reinforcing growth path.”

Stock and bond prices fell, sending market interest rates higher, as the GDP report reinforced a growing consensus that the Fed will hike short-term rates by August to prevent inflation from growing much faster.

Consumer spending, which accounts for 70 percent of the nation’s $11 trillion economic output, was lower than expected in the quarter, although still healthy, showing growth of 3.8 percent. That was down from 5.1 percent in the second half of last year, when a round of tax cuts and mortgage refinancing fueled the strongest growth in 20 years.

The main factor depressing growth in consumer spending was an 18 percent decline in car sales, said Dean Baker, co-director of the Center for Economic and Policy Research in Washington.

“The sales rate in the second half of 2003 was extraordinary, so a drop was predictable,” he said.

The public sector contributed 0.4 percent of the quarter’s growth, as a 15 percent increase in defense spending more than offset a 2.6 percent decline in spending by state and local governments.

Higher spending on defense and homeland security is a fact of life in the post 9/11 world and will continue to contribute to growth for years to come, said John Silvia, chief economist of Wachovia Securities.

“I think you’ve ended the Clinton 1990s era where you cut real defense spending,” he said. “The reality is we’re going to spend more on defense and homeland security than we did before.”

At 2.5 percent, inflation was still modest in the quarter, but up sharply from the 1.5 percent rate in the previous quarter. A falling dollar and rising commodity costs have boosted import prices, while strong demand from consumers has allowed some producers to push through long-delayed price increases.

Ethan Harris, chief U.S. economist for Lehman Bros., said inflation is unlikely to accelerate, but he worries that central bankers will be forced to raise short-term rates sooner than they would have wanted to.

“This surprising surge in inflation is causing a problem for the Fed,” he said. “The risk is that the Fed is forced into a tightening despite an economy that really isn’t that strong in terms of growth.”

In testimony before a congressional panel last week, Greenspan suggested he is not yet concerned about rising inflation because employment growth has been so sluggish since the recession ended in late 2001. With plenty of slack in the labor market, there has been little upward pressure on wages, which is typically what causes  spiraling prices that have devastated the U.S. economy in the past.

Although labor costs, which compose nearly two-thirds of consolidated costs, no longer seem to be falling at the pace that prevailed in the second half of last year, those costs have yet to post a decisive upturn,” Greenspan noted in his testimony last week.

Indeed, a separate government report confirmed Thursday that wages inched ahead at 0.6 percent in the first quarter, although benefit costs surged 2.4 percent, the fastest rate since 1982.

The economy is a central issue in the presidential campaign, turning each month's employment report into a major event for politicians and financial markets. Democratic presidential hopeful John Kerry has made job creation a central part of his campaign platform, saying he would roll back tax cuts for the wealthy to help keep manufacturing jobs at home rather than ship them overseas. Bush and his aides say a report that the economy added 308,000 jobs last month -- the best result in four years -- is evidence that his policies are working.

Even as the Fed is coming under increasing pressure, few analysts worry about inflation after a  year when the main concern of monetary policy-makers was deflation, or falling price.

“I don't think we're at a point yet where we have to worry,” said Bill Cheney, chief economist of MFC Global Investment Management.

“A significant part of the first-quarter inflation was the direct result of increased energy prices, which are unlikely to keep rising,” he said in a note. “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.”

Larry Horwitz, senior economist for Decision Economics, said his only major worry is that China mismanages efforts to slow its overheating economy.

“Given that China and the U.S. are the major sources of growth in global demand what happens in China could be a serious blow to that growth,” he said. “We know that the (Chinese) government is clearly trying to engineer a soft landing. … There is no reason to expect that there would be any kind of serious overshoot at this point, but it is a risk.”

Baker, co-director of the Center for Economic and Policy Research, sees a more serious risk as long-term interest rates rise, ending a long cycle of mortgage refinancing that has buoyed corporate spending. Long-term mortgage rates have been rising for nearly a month, sending a benchmark 30-year mortgage rate above 6 percent for the first time since December.

Baker also fears that higher mortgage interest rates will cap housing prices and even cause prices to decline in many hot housing markets with potentially serious ripple effects on the economy.

But Baker clearly is in the minority.

Horwitz, of Decision Economics, said the impact of higher interest rates should be more than offset by rising job growth.

“The creation of net new jobs is much more important than refinancing or any of the other benefits people have been able to take advantage of over the last couple of years,” he said.

Given the growth in production and new orders, “it would be very, very unusual, even impossible” to continue with the slow job growth seen earlier this year, Horwitz said.

© 2013 msnbc.com Reprints

Discuss:

Discussion comments

,

Most active discussions

  1. votes comments
  2. votes comments
  3. votes comments
  4. votes comments

Data: Latest rates in the US

Home equity rates View rates in your area
Home equity type Today +/- Chart
$30K HELOC FICO 2.79%
$30K home equity loan FICO 5.78%
$75K home equity loan FICO 4.54%
Credit card rates View more rates
Card type Today +/- Last Week
Low Interest Cards 13.57%
13.57%
Cash Back Cards 17.91%
17.91%
Rewards Cards 17.15%
17.15%
Source: Bankrate.com