The U.S. economy expanded at a faster-than-expected clip in the last quarter of 2022, driven by a solid pace of spending. Yet, momentum had slowed significantly, with higher interest rates eroding demand and widespread fears of a looming recession.

The Commerce Department's advanced fourth-quarter gross domestic product (GDP) report on Thursday also showed growth getting a big boost from a sharp rise in inventory accumulation, some of which is likely unwanted. Business spending on equipment contracted in the fourth quarter.

It could be the last quarter of solid growth before the lagged effects of the Federal Reserve's (Fed) fastest monetary policy tightening cycle since the 1980s are fully felt. Most economists expect a recession by the second half of the year, though mild compared to previous downturns, because of extraordinary labor market strength.

Retail sales have weakened sharply over the last two months, and manufacturing looks to have joined the housing market in a recession. While the labor market remains strong, business sentiment continues to sour, which could eventually hurt hiring.

Losing stamina

"The U.S. economy isn't falling off a cliff, but it is losing stamina and risks contracting early this year," said Sal Guatieri, a senior economist at BMO Capital Markets in Toronto. "That should limit the Fed to two more small rate increases in coming months."

The government said in its estimate on Thursday that GDP increased at a 2.9% annualized rate last quarter. The economy grew at a 3.2% pace in the third quarter. Economists polled by Reuters had forecast GDP would rise at a 2.6% rate.

Robust second-half growth erased the 1.1% contraction in the year's first six months. For 2022, the economy expanded by 2.1%, down from 5.9% in 2021. Last year, the Fed raised its policy rate by 425 basis points from near zero to a 4.25%-4.50% range, the highest since late 2007.

Consumer spending, which accounts for over two-thirds of U.S. economic activity, helped power growth, mainly reflecting a rebound in goods spending at the start of the quarter, mainly on motor vehicles. Consumers also spend on healthcare, housing, utilities, and personal care.

Spending has been underpinned by labor market resilience as well as excess savings accumulated during the COVID-19 pandemic. After accounting for inflation, income at the disposal of households increased at a 3.3% rate after rising at a 1.0% pace in the third quarter. The saving rate rose to 2.9% from 2.7%.

But demand for long-lasting manufactured goods, mostly bought on credit, has fizzled, and some households, significantly lower income, have depleted their savings.

As a result, inventories surged at a $129.9 billion rate compared to a $38.7 billion pace in the prior quarter. As a result, lists added 1.46 percentage points to GDP growth. However, stripping out inventories, government spending, and trade, domestic demand increased at only 0.2%, decelerating from the third quarter's 1.1% pace.

Rolling recession

Despite clear signs of a weak handover to 2023, some economists are cautiously optimistic the economy will skirt an outright recession, suffering instead a rolling downturn where sectors decline in turn rather than all at once.

They argue that monetary policy now acts with a shorter lag than was previously the case because of technological advances and the U.S. central bank's transparency, which resulted in financial markets and the real economy acting in anticipation of rate hikes.

Residential investment suffered its seventh straight quarterly decline, the longest such streak since the housing bubble's collapse triggered the 2007-2009 Great Recession. Still, there are signs the housing market could be stabilizing.

Mortgage rates have been trending lower as the Fed slows the pace of its rate hikes.

A separate report from the Labor Department on Thursday showed initial claims for state unemployment benefits dropped 6,000 to a seasonally adjusted 186,000 for the week ended Jan. 21, the lowest level since April 2022.

The number of people receiving benefits after an initial week of aid, a proxy for hiring, increased from 20,000 to 1.675 million for the week ended Jan. 14.

Companies outside the technology industry and sectors sensitive to interest rates, like housing and finance, are hoarding workers after struggling to find labor during the pandemic.