(Bloomberg) -- The US economy was slowing even before the brunt of any credit crunch stemming from the recent bank failures, while inflation accelerated, highlighting the enormous challenge faced by the Federal Reserve.

Gross domestic product rose an annualized 1.1% in the first quarter, notably less than the median forecast for 1.9% in Bloomberg’s survey, Bureau of Economic Analysis data showed Thursday.

The slowdown was largely driven by an inventory drawdown, with an acceleration in consumer spending providing the main impetus for growth. Still, economists warned that momentum slowed as the quarter progressed, in a warning sign for the current quarter.

Frustratingly for the Fed, the central bank’s preferred core gauge of prices, which excludes food and energy, picked up to 4.9% in the January-through-March period, the quickest pace in a year. Meantime, a separate report underscored enduring strength in the labor market, with weekly jobless claims unexpectedly dropping.

It all adds up to a strengthened case for Fed Chair Jerome Powell and his colleagues to raise rates another 25 basis points at the May 2-3 policy meeting. Two-year Treasury yields climbed on that bet Thursday morning. It also suggests a higher risk of a stagflationary environment, where the economy slumps while inflation sticks at a pace well above the Fed’s 2% target.

“This morning’s data was the worst of both worlds, with growth down and inflation up,” said Chris Zaccarelli, chief investment officer at Independent Advisor Alliance.

Data due Friday will offer a more detailed look at how consumer spending evolved during the quarter. Economists are penciling in a 0.1% drop in real personal outlays for a second month March after a 1.5% jump for January — when warm weather bolstered retail sales.

“Consumption was weak late in the quarter,” Morgan Stanley’s US economists, led by Ellen Zentner, said in a note. In addition to weather pulling spending forward, less federal support to lower-income households for food expenses also played a role in the tempering of purchases late in the quarter, they wrote.

Zentner and her colleagues said they “expect to see significant slowing into second-quarter 2023 as the cumulative effect of tighter monetary policy as well as banking pressures push growth into negative territory.”

Economists are forecasting GDP to grow at a stall-speed pace of 0.2% this quarter, a Bloomberg survey shows.

Among the takeaways for the first quarter:

  • The 3.7% annualized increase in consumer spending reflected gains in both goods and services, including a surge in purchases of motor vehicles
    • Services rose 2.3%, led by health care as well as restaurants and hotels
    • Spending on goods increased 6.5%, the most in nearly two years
  • Business outlays for equipment posted the biggest drop since the start of the pandemic, with a 7.3% annualized decline
  • Inventories subtracted the most from GDP in two years, lopping 2.26 percentage points off of GDP

Inflation-adjusted final sales to private domestic purchasers — a key gauge of underlying demand — rose the most since the second quarter of 2021 after stagnating at the end of last year. The figure was boosted by the consumer spending figures.

What Bloomberg Economics Says...

“The US economy is stronger than meets the eye, with consumers continuing to spend on both goods and services. While GDP grew just 1.1% overall in the first quarter, final sales to domestic purchasers rose a much stronger 3.2%, dispelling recessionary fears for now.”

— Eliza Winger, economist

For the full note, click here

Futures trading showed investors putting about 90% odds on a 25 basis-point rate hike by the Fed next week, up from 79% late Wednesday.

Separate data out Thursday showed applications for unemployment benefits fell for the first time in three weeks. Continuing claims, which can offer insight into how quickly out-of-work Americans are able to find a new job, were largely unchanged.

“Inflation remains stubborn, and along with the continued strength in the labor market, it should keep the Fed on pace for a May and potentially a June rate hike,” said Cliff Hodge of Cornerstone Wealth.

--With assistance from Peyton Forte and Augusta Saraiva.

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