Originally Published: 27 APR 23 08:32 ET

Updated: 27 APR 23 13:18 ET

By Bryan Mena, CNN

(CNN) -- US economic growth slowed to an annualized and seasonally adjusted rate of 1.1% in the first quarter of this year, as businesses rebalanced their inventories and pulled back on spending amid punishing rate hikes from the Federal Reserve.

The increase in gross domestic product — the broadest measure of economic activity — was far below economists' expectations of 2% and represents a more moderate pace compared to the previous two quarters, according to data released Thursday by the Department of Commerce.

The January-to-March period was also marked in its later weeks by mounting fears that a meltdown in the banking sector and a pending debt ceiling crisis could trigger a recession.

The GDP report affirms that the US economy has lost momentum in recent months, with many economists also forecasting a recession later in the year. The Federal Reserve has been striving for months to cool the economy, which has remained strong despite nine straight rate hikes.

"The slightly cooler than expected GDP report will not prevent the Fed from making another quarter percentage point rate hike at its decision next Wednesday," said Bill Adams, chief economist for Comerica Bank. "The Fed wants the economy to run below potential for a while to allow supply and demand to get into better balance."

Strong consumer spending belies slowing business investment

Consumer spending, which accounts for more than two-thirds of economic output, contributed the most to the first quarter's growth as Americans continued to spend robustly on goods and services, especially in restaurants and bars.

Spending was stronger compared with the previous quarter, led by purchases of cars and vehicle parts and health care services. Meanwhile, a rise in imports and a sharp decline inventories dragged on growth.

However, high inflation and the Federal Reserve's yearlong rate-hiking campaign weighed on business spending, which fell in the beginning of the year. Residential and nonresidential investment declined for the fourth consecutive quarter.

Robust economic activity in January helped to drive the overall growth in the first quarter, economists said.

In January, consumer spending advanced a solid 2% and employers added close to half a million jobs. Spending and payroll growth cooled in the following months as inflation, higher borrowing costs, and colder weather weighed on output. The 236,000 jobs added in March was the smallest monthly gain in more than two years and household spending grew by a modest 0.2% in February.

Spending on goods and services in the January-through-March period was the strongest since the second quarter of 2021.

But spending is expected to fizzle out in the coming months because that strength earlier in the year was due to higher credit card usage, a drawdown in savings, warmer weather, and "increased reliance on sputtering state and local stimulus programs," said Lindsey Piegza, chief economist at Stifel Financial.

"Instead of the consumer continuing to pull back, we saw a lot of that temporary support hold up spending in the first quarter or, as I like to describe it, the consumers' last stand," Piegza said. "Most of those supports will not prove lasting, so it's likely that growth will continue to slow under the weight of elevated inflation and as the Federal Reserve continues to raise rates."

Strong decline in business investment

Business spending, which is highly sensitive to the direction of the economy, remained in contraction territory in the first quarter as companies cut back on equipment, and residential fixed-investment firms continued to struggle.

"This data, while firmly in the rearview mirror, illustrates that American firms are growing increasingly concerned regarding the sustainability of the current business cycle as the lagged impact of rate hikes, elevated inflation and tighter lending which is now evident inside the real economy will all combine to finally cause the consumer to capitulate later this year," Joseph Brusuelas, chief economist at RSM US, wrote in an analyst note.

Business investments are often made through credit, so higher borrowing costs coupled with slowing economic activity can curb those investments, but that also varies depending on the size of a firm, said Eugenio Aleman, chief economist at Raymond James.

"Small businesses, which typically use their own cash flows instead of borrowing, have continued to invest in the economy, so nonresidential fixed investments have continued to expand, but their contribution to GDP growth is very small," Aleman said.

Residential fixed investment, which includes construction of housing units, dragged on growth in the first quarter as rising interest rates continued to take a toll on the interest rate-sensitive housing market, despite a brief reprieve from rising mortgage rates earlier in the year.

Recessionary forecasts

Economists, including those at the Federal Reserve, expect the US economy to tilt into a recession later in the year. Aleman said that he expects the economy to grow by an annual rate of 0.8% in the second quarter, then to enter a mild recession in the third quarter, mostly due to the effects of tighter monetary policy.

Some businesses remain optimistic in their outlooks for the rest of the year.

Adrian LaTrace, chief executive of Boyd Industries, a manufacturer of dental equipment based in Clearwater, Florida, said that activity in the first three months of year wasn't as strong as last year, and instead resembled pre-pandemic times. Still, he said sales for the quarter were up about 10% and that quotes for equipment orders have been strong. He said part of that was likely due to deferred patient loads that dental offices are chipping away at, helping sustain activity.

"I don't see sales being affected significantly in any unfavorable way the rest of the year, and we are dealing with input cost pressures related to materials, which have normalized a bit, but the biggest challenge I see is on the labor force side," LaTrace said.

LaTrace said his company has struggled to hire workers across the board, which he said has held back the company's expansion.

"If we can get even more rank-and-file employees for the factory with certain skill sets and for the sales and customer service side, I have no doubts that we can continue to grow the company and perhaps even at a faster rate than what we're growing presently," LaTrace added.