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The U.S. economy might still be too strong for its own good

The economy is slowing all right, but oddly, it might still be too strong to get inflation to fall much faster and help the U.S. avoid recession.

Gross domestic product, the official scorecard of the economy, decelerated to a 1.1% annual rate of growth in the first three months of this year. That’s down from 2.6% and 3.2% in the prior two quarters.

The slowdown in growth is exactly what the Federal Reserve is aiming for.

The central bank is trying to pull a rabbit out of a hat by cooling off the economy enough to extinguish the highest inflation since the 1980s and avoid a recession at the same time.

To achieve its goal, the Fed has jacked up a key U.S. interest rate above 5% from near zero over the past 15 months. Higher borrowing costs slow the economy by reducing consumer spending and business investment.

The strategy appears to be working. The yearly rate of inflation tapered off to 4.9% in April from a 40-year peak of 9.1% last summer.

Yet it’s far from clear the economy will slow enough to put inflation on a track to reach the Fed’s 2% target without further interest-rate increases. The Fed raised rates again earlier this month, but signaled it hopes to stand pat for the rest of the year.

The early evidence in the second quarter is mixed.

Consumer attitudes about the economy soured in May amid talk of recession and looming U.S. debt-ceiling crisis, for one thing.

Americans have also cut spending on many big-ticket items such as furniture and appliances and they are leery of taking on major new debt. Since last summer the savings rate has almost doubled to 5.1% from a 17-year low .

The latest earnings report from Home Depot underscores the problem.

Home Depot posted lower first-quarter profits and said sales this year could fall for the first time since 2009, when the U.S. was exiting a severe recession.

The popular retailer sells many expensive goods such electric tools and appliances and provides the materials needed for many major home projects. These are the sorts of purchases Americans are putting on hold.

Yet other measures show the economy is still expanding at a modest pace — and that it may have even perked up.

Take retail sales. They rose in April for the first time in three months, led by an increase in auto sales.

“Retail sales came in strong again, showing how the consumer isn’t showing any signs of slowing down,” said Chris Zaccarelli, chief investment officer at the Independent Advisor Alliance 

Steady demand for new cars and trucks, in turn, has spurred automakers to ramp up, especially with shortages of key parts continuing to ease. U.S. industrial production rose 0.5% in April after stalling out for two months, mostly because of the auto industry.

Auto sales are on track to increase sharply this year after falling to an 11-year low in 2022. Why is that a big deal? Recessions are basically unheard of absent an outright decline in car buying.

It’s not just cars, either.

Consumers aren’t spending as much on goods, but services are another matter. They have spent the bulk of their discretionary income on travel, recreation and dining out, the sort of things that are the first to go when times get tough.

Hotel bookings, plane-ticket purchases and dinner reservations are all near pre-pandemic peaks — definitely not a sign of an approaching recession.

The early read on second-quarter GDP, not surprisingly, is fairly positive. The Atlanta Federal Reserve’s GDPNow estimates growth at 2.9%. JPMorgan is more modest at 1%. And Nomura is at 0.7%.

What’s keeping the economy going despite sharply higher borrowing costs is the strongest labor market in decades. Businesses are still hiring and the economy is still adding jobs, keeping the unemployment rate at an extremely low 3.4%.

Even a recent increase in layoffs, as represented by rising jobless claims, overstates emerging weakness in the labor market. Major fraud in Massachusetts appears to have exaggerated how many job losses are taking place in the economy.

A tight labor market would normally be a great thing. Now it’s a double-edged sword.

Workers are reaping bigger pay increases to help them cope with higher prices, but rapidly rising wages are also adding to high inflation. Businesses have tried to offset higher labor costs partly by charging more for their goods and services.

The uber-strong labor market leaves the Fed in a bind.

If job openings and hiring don’t weaken a lot further, the economy is likely to grow fast enough to maintain the upward pressure on inflation. The Fed could be forced to come off the sidelines and raise interest rates again, raising the odds of a recession.

Several senior Fed officials indicated this week they have not seen enough evidence to support a freeze in interest rates for the rest of the year.

“Should inflation remain high and the labor market remain tight, additional monetary policy tightening will likely be appropriate,” said Fed Gov.  Michelle Bowman.

Even if the Fed doesn’t raise rates again, though, many Wall Street

economists think a recession is inevitable by the end of the year. They view the seeming green shoots in April as a feint, pointing to softer consumer spending, waning business investment and the slumping housing and manufacturing industries.

“The march to recession continues, with some rest stops along the way,” said chief economist Steve Blitz of TS Lombard.

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