Economy shrinks a more-than-expected 6.1% in Q1

— -- The U.S. economy contracted at a swift pace in early 2009 as sharp drops in business spending and inventories more than offset the biggest rise in consumer spending in two years, the government said Wednesday in a report that still offered hopeful signs the economy may soon turn a corner.

Gross domestic product, the broadest gauge of U.S. economic activity, fell at a seasonally adjusted annual rate of 6.1% in the January-March quarter after dropping 6.3% in the fourth quarter, the worst in a quarter-century, the Commerce Department said. It was the first time GDP contracted for three consecutive quarters since 1974-75.

But many economists said there were some positives in the report, such as the increase in consumer spending, that suggested the news for the second quarter will be better.

Insight Economics President Steven Wood said government spending will also be a positive in the second quarter as stimulus money is spent.

"Although there have been large back-to-back declines in economic activity, the composition of the most recent decline is actually favorable" for the second and third quarters, he said. "Any declines should be much smaller, and there is a possibility that at least one of those quarters could register small positive growth."

A look at some of the key components of the report:

Consumer spending, up 2.2%

There was some positive news from the consumer in the first quarter. Consumer spending, which accounts for more than two-thirds of all U.S. economic activity, rose 2.2% in the January-March quarter, the biggest increase since the first quarter of 2007. Consumers increased spending on a wide range of items, including cars, furniture, clothing, medical care and recreation. Their spending added 1.5 percentage points to GDP in the first quarter.

"Tax cuts and expanded government spending are supporting incomes, and households may feel that they have cut back enough on their spending," said Augustine Faucher, director of macroeconomics at Moody's Economy.com.

Still, some economists questioned whether consumers will be able to increase spending in coming quarters.

"We expect a weak trajectory of consumer spending given the headwinds from rising unemployment and diminished household wealth," Barclays Capital economists Michelle Meyer and Ethan Harris said in a note to clients.

Consumers have a long way to go to get back to their shop-till-you-drop ways seen before the recession began. The gain in consumer spending at the beginning of the year follows two consecutive quarters of large spending drops. And consumers are continuing to show caution: The personal saving rate was 4.2% in the first quarter, up from 3.2% at the end of 2008 and the highest in more than a decade.

Business investment, down 37.9%

Businesses drastically cut their spending on equipment and software and structures in the first quarter, leading to a record 37.9% plunge in overall business investment.

That followed a 21.7% drop in the fourth quarter and was the biggest decline since quarterly records began more than 60 years ago. The drop subtracted 4.7 percentage points from GDP.

"Essentially, firms assumed what I have nicknamed 'the turtle position,' " Joel Naroff of Naroff Economic Advisors said in a note to clients. "If it wasn't absolutely needed, it didn't get bought."

PNC economists Stuart Hoffman and Robert Dye said such aversion on the part of businesses to spending money pointed to "ongoing losses in payroll jobs for the remainder of this year."

Since the recession began in December 2007, 5.1 million jobs have been cut, bringing the unemployment rate to 8.5% in March, the highest in more than a quarter-century.

U.S. exports, down 30%

The downturn is global, a point driven home by the sharp falloff in sales of U.S. goods abroad.

Exports fell at a 30% annual rate in the first quarter after falling at a 23.6% rate in the fourth quarter. The drop in the beginning of 2009 was the biggest in 40 years. Exports subtracted 4.1 percentage points from GDP in the first quarter.

But imports also dropped steeply, leading trade to actually be a net positive for the economy in the first quarter. Falling imports serve to boost GDP.

Exports are unlikely to be in the plus column for the U.S. economy for some time, economists predicted.

"As the global economy falls into a deeper recession, exports are likely to weaken," California State University economics professor Sung Won Sohn said.

Inventories, down $104 billion

Businesses are responding to the sharp downturn in the economy by rapidly liquidating their inventories. In the first quarter, companies slashed $104 billion in inventories, more than four times the amount they cut in the fourth quarter. The inventory liquidations subtracted 2.8 percentage points from GDP.

Although inventory liquidation is a negative for GDP, a number of economists said the quick movement on the part of businesses could bode well for upcoming quarters. With inventories low, businesses will need to restock shelves quickly when demand picks up.

"Modern supply-chain management dictates that management must execute swift adjustments to fluctuating demand conditions, and that is exactly what we got," said Brian Bethune, chief U.S. financial economist at economic consulting firm IHS Global Insight.

"While inventories are likely to decline in the second quarter, it is very unlikely that they will decline at a rate much greater than what we saw in the first quarter," he said. "That would add … to growth right out of the starting gate."

Housing investment, down 38%

Housing investment fell 38% in the first quarter, the biggest drop since 1980 and the 13th-consecutive quarterly decline. Housing subtracted 1.4 percentage points from GDP last quarter. The market isn't expected to come roaring back, but economists said big declines may be past. "More timely home-sales-related data have signaled some improvement," UBS said in a note to clients.

Government spending, down 3.9%

For the first time in more than three years, government spending declined in the first quarter as federal spending on defense as well as outlays by state and local governments dropped.

Government spending dropped 3.9% in the first quarter, the biggest decline since the end of 1995, and subtracted 0.8 of a percentage point from GDP.

But economists said government spending will likely be a boost starting in the second quarter as the $787 billion stimulus bill begins to be spent throughout the economy.

"We should expect federal government outlays to start soaring and state and local expenditures to show the impact of the stimulus bill," Naroff says.