The Real Reason 1Q GDP Took a Hit

By John Carney

June 26 (CNBC) — The economy grew more sluggishly in the first three months of the year than the government first reported, as higher taxes on payrolls dampened consumer spending and held overall growth down to just a 1.8 percent annual rate.

Make no mistake about it: this is really grim. And to make matters worse, it’s something we did to ourselves.

The Commerce Department had earlier estimated growth at 2.4 percent. Most economists expected that number to remain when the final revision came out Wednesday.

This follows an expansion of just 0.4 percent in the fourth quarter of last year.

The biggest source of the downward revision came from consumer spending. Government economists had estimated that consumer services consumption (excluding housing and utilities) would grow by 2.5 percent, instead it grew at just 0.7 percent.

That’s stall speed for consumers. Far worse, in fact, than the 2.4 percent growth seen in the fourth quarter.

There were also downward revisions to nonresidential structures investment, equipment and software spending, and the change in inventories. Government spending shrunk by slightly less than expected, so the sequester spending cuts weren’t as big of a deal as some predicted. Residential investment was up by far more than expected, 14.0 percent.

The main culprit behind the consumer pullback seems to be what Fed Chairman Ben Bernanke calls “fiscal headwinds.” Specifically, the end of the payroll tax holiday left less money in the hands of consumers to spend. We taxed ourselves out of growth.

“The lower consumption estimate provides some indication that the impact from fiscal austerity may have been more than previously thought, and that the economy started the year on weaker footing than previous estimated,” TD Securities analyst Millan Mulraine wrote in a note.

But don’t entirely discount the federal spending cuts known as “sequester,” which kicked in on March 1. Even though the sequester did not directly diminish government spending by as much as possible, its anticipated effects may have dampened investments.

Gross private investment was revised down to 7.4 percent growth from the estimate of 9.0 percent. Commercial investment fell 8.3 percent, compared with an estimated fall of just 3.5 percent. Business investment was revised down slightly lower to 4.1 percent from 4.6 percent. Those drops likely reflect a projected weakness in the economy going forward.

That growth could fall so low in a quarter in which the Federal Reserve was engaging in a new round of quantitative easing, buying $85 billion of bonds each month, might cast doubt on the effectiveness of the program. That would be bad news for stocks, which rose for the first four months of the year on the idea that QE could prop up a weak economy. (And have recently fallen after the Fed began to explain when it would pare back the program.)

“‘QE on’ was a misguided speculative bubble in any case, as QE is, at best, a placebo, and in fact somewhat of a tax as it removes a bit of interest income,” bond investor Warren Mosler said.

Mosler is a long-term critic of QE. He believes that because the interest paid on bonds the Fed buys under the program gets paid to the Fed instead of private bond holders, it acts as a tax on the private sector. The economic benefits are illusory, according to Mosler.

On the other hand, sluggishness in the economy could mean that expectations about the Fed tapering QE and raising rates get pushed back. Bernanke has stressed that decisions about policy changes would be dependent on economic data.

Wednesday’s news about the first quarter, while backward looking, certainly casts doubt on whether the economy is strong enough to justify lower levels of bond purchases.

Not everyone buys that way of thinking, however. Some doubt that Wednesday’s news will have any effect on the Fed’s plan to reduce the bond-buying program.

“The Fed will presumably continue to maintain its primary focus on labor market data, so while this revision obviously will impact their thoughts at the margin, I highly doubt that it will be a game changer, especially since I am skeptical that policymakers are as data-dependent as they want to believe,” Stephen Stanley of Pierpont Securities wrote in a note Wednesday morning.