Slower U.S. growth might lead Fed to keep up stimulus

The U.S. economy may not be strong enough for the Federal Reserve to slow its bond purchases later this year.

That's the takeaway from economists after the government cut its estimate Wednesday of growth in the January-March quarter to a 1.8-percent annual rate, sharply below its previous estimate of a 2.4-percent rate. The main reason: Consumers spent less than previously thought.

Most economists think growth will remain low as consumers and businesses continue to adjust to federal spending cuts and higher taxes. Growth is expected to reach an annual rate of only about 2 percent in the April-June quarter. Even if the economy improves slightly, it would be hard to meet the Fed's forecast of 2.3-percent to 2.6-percent growth for 2013.

Chairman Ben Bernanke rattled investors last week when he said the Fed will likely slow its bond-buying this year if the economy continues to strengthen. The bond purchases have helped keep interest rates low. Bernanke added that if the economy weakens, the Fed won't hesitate to delay its pullback or even step up its bond purchases again.

Jennifer Lee, senior economist at BMO Capital Markets, said that if the April-June quarter proves tepid, the Fed will be looking at three straight quarters of subpar growth.

"The Fed won't taper (its bond purchases) under these conditions," Lee said. "They need convincing signs of a pickup."

Joel Naroff, chief economist at Naroff Economic Advisers, said he suspects the Fed will wait until next year to slow its bond buying. Like most economists, Naroff thinks growth will pick up in the October-December quarter and strengthen in 2014.

"If the Fed doesn't take notice of this revision to growth, they would run the risk of being perceived as largely clueless about the economy," Naroff said.

Stocks surged Wednesday, a sign that many investors also suspect the economy may prove too weak for the Fed to begin scaling back its stimulus later this year. The Dow Jones industrial average closed up nearly 150 points. Broader stock indexes also surged.

Most of the revision to last quarter's growth was due to a decline in consumer spending to an annual rate of 2.6 percent. Though that pace is the fastest in two years, it's sharply below the 3.4-percent rate previously estimated .

A key factor was weaker spending on services, such as travel, legal services, health care and utilities. Spending on long-lasting manufactured goods, considered a barometer of consumers' confidence in the economy, was stronger than previously estimated.

Some economists said the lower estimate suggests that an increase in Social Security taxes that took effect this year might be squeezing consumers more than expected. The tax increase has reduced take-home pay for most Americans. A person earning $50,000 a year has roughly $1,000 less to spend. A high-earning couple has up to $4,500 less.

"There was still acceleration in the growth of consumer spending — just not as much," said Paul Edelstein, director of financial services at IHS Global Insight.

The government's revisions also pointed to less export growth and weaker business investment spending, due mainly to less spending on buildings than previously estimated.

For each quarter, the government issues three estimates of growth as it collects increasingly precise data on the nation's gross domestic product. GDP reflects the economy's total output of goods and services, from haircuts to aircraft carriers.

In Wednesday's third and final estimate of first-quarter growth, for example, the government lowered its figure for consumer spending based on newly available data from a quarterly Census Bureau survey of services spending.

Edelstein cautioned that the government has trouble calculating spending on services. The estimate could change further next month, when the government will issue the revisions it makes to GDP every five years. These revisions incorporate data from the Census Bureau, Internal Revenue Service and other agencies.

Wednesday's revision of 0.6 percentage points was larger than the government usually makes in its third estimate of GDP. From 1983 through 2009, the average change from the second to third estimate was 0.2 percentage point, the department says.

But the change from the first estimate to its third one — from an annual rate of 2.5-percent growth to a 1.8-percent rate — was close to the average: 0.6 percentage point.

"We do not want to overreact to the Q1 data," said Joseph LaVorgna, chief U.S. economist at Deutsche Bank Securities. He noted that the government has tended to revise up its monthly employment data — a trend, that if it continued, would "suggest on balance that real GDP growth could be understated."

The biggest drag on the economy remains government spending. It fell during the first quarter at an annual rate of 4.8 percent. That shaved 0.9 percentage point from growth.

Economists expect steep federal spending cuts to continue to weigh on growth in the second and third quarters. Edelstein predicts annual growth rates of just 1.5 percent in the current quarter and 1.8 percent in the July-September quarter.

Naroff is more optimistic than most: He's forecasting annual growth rates of 2.5 percent in both quarters.

Still, both think the Fed is unlikely to scale back its bond purchases until annual growth moves closer to 3 percent.

Mark Zandi, chief economist at Moody's Analytics, said he suspects the Fed will wait until its December meeting to slow its bond purchases, rather than in September as many have been predicting.

Zandi thinks the unemployment rate should reach 7 percent by the middle of next year, in line with the Fed's projections. It's now 7.6 percent.

The latest economic reports have been encouraging. U.S. factories are fielding more orders. Higher home sales and prices are signaling a steady housing recovery.

Spending at retail businesses rose in May. And employers added 175,000 jobs last month, which almost exactly matched the average increase of the previous 12 months.

Stable job growth has gradually reduced the unemployment rate to 7.6 percent from a peak of 10 percent in 2009. And it's lifted Americans' confidence in the economy to its highest point in 5-1/2 years.

"If growth accelerates in the fourth quarter, and that is followed by better growth next year, that would be the development that is necessary to convince everyone on the Fed that there are minimal risks to the economy from starting to taper the bond buys," Naroff said. "I don't see that happening until the spring."