US recovery hopes grow even as economy contracts 6.1%

Fed holds rates, and notes improvement for first time

A rebound in consumer spending combined with the aggressive actions of business owners to position the US economy for a return to growth later this year, economists concluded yesterday, even as GDP shrank more than expected in the first three months of 2009.

US economic output contracted at an annualised rate of 6.1 per cent in the first quarter, almost as bad as the minus 6.3 per cent GDP figure for the final three months of last year, when consumers and businesses were reeling from the collapse of Lehman Brothers.

Business investment contracted by a record 37.9 per cent, as firms scrapped expansion plans and axed jobs, pulling down overall output. GDP was also hit by a record $103.7bn (£70.2bn) reduction in inventories, or stockpiles of unsold goods – and while that accounted for 2.8 percentage points of the decline, it was hailed as good news by many economists.

Christina Romer, the head of the White House council of economic advisers, said: "To the degree that there's a sign that firms are bringing down some of their inventories, that, combined with consumers coming back to life, could mean we need to start producing things again," she told Reuters television. "It could put us in a position for perhaps a less dreary number going forward."

Other "green shoots" in the report included a surprisingly strong uptick in consumer spending, which contributed 1.5 percentage points to GDP, where it had been a net negative for the two previous quarters. Information on the price of goods and services helped to ease the fear of deflation taking hold. And economists also dismissed an unexpected drop in government spending as temporary.

Stock markets surged in response to this closer reading of the data, and the Dow Jones Industrial Average climbed 169 points, or 2.1 per cent, to 8,186. Global stock markets rose, too, in the hope the country which led the world into recession might now be closer to leading the way out of it, too. The FTSE 100 closed 93 points higher at 4,190.

Investors were further buoyed by the outcome of a two-day meeting by the Federal Reserve's open market committee (FOMC), which kept US interest rates at near-zero and reiterated its plans to pump $1.75trn into the credit markets to push down long-term rates and the cost of mortgages. In the accompanying statement, the FOMC said for the first time that the economic outlook had improved, although it kept up its dire warnings of the risks ahead. "Although the economic outlook has improved modestly since the March meeting, partly reflecting some easing of financial market conditions, economic activity is likely to remain weak for a time," it said.

For all the optimism, yesterday's headline number for US GDP was shocking, since Wall Street had expected only something around minus 4.6 per cent. Not since 1958 has the US experienced such a sharp contraction over six months, and the economy has now been shrinking for three straight quarters, the first time it has done so since the 1974-75 recession. This downturn, which began in December 2007, would next month become the longest since the Great Depression.

And not all economists were convinced a recovery later this year is locked in. Peter Schiff, of Euro Pacific Capital, told clients: "With the collapse of the housing and stock markets, the surge in unemployment, and the fall in wages, the only way that consumers can spend more is if they reduce savings or increase borrowing. However, our economy collapsed precisely because we borrowed and spent too much to begin with. The economy will not find a solid foundation unless consumers decide to live within their means. Sadly that message is not getting out."