The United States economy contracted for the first time in nearly three years, with GDP shrinking by 0.3% on an annualised quarter-on-quarter basis in the first quarter of 2025, according to ING Chief International Economist James Knightley. The contraction, driven primarily by an extraordinary surge in imports ahead of incoming tariffs, marks the first quarterly decline since Q2 2022 and intensifies fears of stagflation amid stubborn inflation and faltering growth.
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Knightley explained that the downturn came despite solid consumer and business investment performance. 'Consumer spending performed better than we expected, rising 1.8% while non-residential fixed investment was robust at 9.8%, led by a 22.5% increase in equipment investment,' he noted.
However, a dramatic 41.3% surge in imports, prompted by businesses rushing to stockpile goods ahead of anticipated tariffs, severely dragged down net trade, subtracting 4.8 percentage points from overall growth. In contrast, exports edged up by just 1.8%. 'This surge in imports did result in a sharp rise in inventories, which added 2.25pp to headline growth and likely helped facilitate the strong increase in equipment investment,' Knightley added.
Federal government spending also weighed on the economy, falling 5.1%, and pulling overall public expenditure down by 1.4%.
More worrying about policymakers was a surprising uptick in inflation. The core Personal Consumption Expenditures (PCE) deflator, a key metric for the Federal Reserve, rose by 3.5%, exceeding the 3.1% market consensus. This signals persistent price pressures even before the full impact of tariffs and potential supply disruptions later in the year. 'Rather concerningly the price metrics were firmer than anticipated,' said Knightley.
As a result, the narrative of stagflation, where inflation persists despite economic stagnation, is gaining traction. 'Given this situation, the stagflation narrative is likely to continue to dominate economic debate,' Knightley warned. He pointed to falling consumer confidence, continued government spending cuts, and business hesitancy over tariffs and supply chains as additional headwinds for growth.
'Yesterday's consumer confidence report suggests the risks are skewed towards a substantial slowdown in consumer spending as households face up to squeezed spending power from higher prices at a time when they are increasingly concerned about job losses and falling wealth,' he explained.
In this environment, the Federal Reserve's ability to respond is constrained. While rate cuts may be necessary later in the year, Knightley said the timing and scale would be critical. 'When the Fed does come to the rescue at some point in the third quarter we suspect they will move hard and fast and fully understand why markets are now pricing 100bp of interest rates cuts for the year versus 79bp this time last week,' he concluded.
With inflation remaining elevated and sentiment weakening, the outlook for 2025 remains clouded, and markets are increasingly bracing for a more aggressive response from the central bank in the months ahead.
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