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Investing.com -- The U.S. economy unexpectedly contracted in the first quarter as the rush to beat the tariff deadline sent imports surging, data showed Wednesday, but the fall in growth masks the underlying strength in domestic demand, Morgan Stanley (NYSE:MS) analysts said in a recent note.
"The drop in GDP in 1Q disguises strength in domestic demand growth," the economists said, driven by a "41% surge in imports ahead of expected tariffs."
Data on Wednesday showed real gross domestic product, or GDP, fell at a 0.3% quarter-on-quarter annual rate, but domestic demand was strong, with consumption up 1.8% and nonresidential fixed investment up 9.8%.
The surge in imports subtracted 5 percentage points from GDP growth, the economists added, while inventories rose enough to add back 2.3 percentage points, indicating that without the surge in imports, economic growth would have positive. This suggests that the GDP weakness is exaggerated because "the imports don’t fully appear in the spending parts of the GDP accounts."
Inflation pressures, meanwhile, also intensified, with core PCE prices rising 3.5% year-over-year, above consensus expectations.
Morgan Stanley noted upside risks to the monthly inflation forecast for March, driven by sectors like financial services, transportation, and healthcare.
As many debate whether this is the peak hit from tariffs, Morgan Stanley cautions that the first-quarter data do not fully reflect the economic impact of ongoing policy changes such as tariffs, government layoffs, and immigration restrictions.
“We continue to expect a surge in inflation, slowing employment growth but little rise in the unemployment rate, and a sharp slowing in real spending,” it added.
Imports are likely to reverse course in Q2, turning from a headwind to a tailwind as the pull-forward tariff-driven demand slows.
While the Q1 growth scare put recession fears front and center once again, the Fed is likely to take comfort from underlying signs of solid demand.
"The Fed can be confident that demand was solid, but the 1Q GDP data do not bear much on the economic effects of ongoing policy changes," Morgan Stanley added.