GDP Revised Up to 2.6% - Analyst Blog

In the third quarter, the economy grew at an annual rate of 2.6% (2.5%, 2.0%), up from 1.7% in the second quarter but down from the 3.7% pace in the first three months of the year. The growth rate was in line with consensus expectations, of 2.6%, but frankly a bit weaker than I was expecting. So how did we get to the 2.6% (2.5%, 2.0%) overall growth? What parts of the economy were growing and thus adding to growth and which parts were acting as a drag on growth?

Since the different parts of the economy are of very different sizes, and some tend to be relatively stable while others can be very volatile, I will focus on the contributions to growth. In other words, growth points, not the percentage growth rates. After all a small percentage change in a very big part of the economy can have more impact than a big percentage change in a small part of the economy. To do this I will follow the familiar Y = C + I + G + (X – M) framework, where Y = GDP, C= Consumption, I = Investment, G= Government, X = exports and M = imports.

The biggest part of the economy by far is the Consumer (consumption), or to be more specific, Personal Consumption Expenditures (PCE). It represented 70.4% of the overall economy in the third quarter, and was the biggest growth driver. PCE contributed 1.67 (1.97, 1.79) growth points, up from 1.54 points in the second quarter and 1.33 points in the first quarter. The increasing contribution to growth (relative to the second quarter) from C is generally a good thing, at least in the short term.

Over the long term, our economy is already weighted too far towards C, and that contribution has been rising over the years. Back in the 1960s, it represented more like 64% of the overall economy. Our consumption share is also far higher than most other economies in the world. Still we need consumers to be opening their wallets for the economy to grow at least in the short term. This is relatively high quality growth, and is very welcome in the current environment. The reduction in the contribution from C is a bit of a disappointment and indicates a deterioration in the quality of the growth relative to the last estimate.

Consumption can be broken down into two main categories: goods and services. Goods can be further broken down into durable goods, which tend to be big ticket items that will last more than 3 years, and Non-Durable goods, which tend to be consumed right away. For some reason clothing is categorized as a non-durable good. Clearly the people making those decisions have never looked into my closet.

Services are by far the biggest part of consumption at 67.15% of PCE and 47.30% of overall GDP. This was where all the downward revision to C came from, with it chipping in just 0.74 (1.16, 1.15) growth points. Down (Up) from just 0.75 points in the second quarter. In the first quarter, services were missing in action, chipping in just 0.03 growth points. The downward revision is discouraging. Services tend to be "produced" domestically, not in China, and also tend to be more labor intensive than goods-producing jobs. Normally demand for services is more stable than demand for goods, especially durable goods.

Within the consumption of goods, consumption of non durable goods is about twice as large as the consumption of durable goods. However since people can defer purchases of durable goods like a car from Ford (F) more easily than they can defer purchase of a box of Corn Flakes from Kellogg's (K), durable goods demand is very volatile. As a result, durable goods tend to "punch above their weight" in determining whether the economy is booming or slumping.

Durable goods consumption added 0.54 (0.53, 0.44) points to growth, up (down) from an addition of 0.49 points in the second quarter and 0.62 points in the first quarter. The relatively flat (downward) trend in contributions from Durable Goods is a bit disconcerting, but is not too bad. The sector is only 10.45% of PCE and 7.36% of overall GDP, yet it contributed 21.2% (22%) of the overall GDP growth in the quarter. On the other hand, coming out of recessions, Durable Goods are usually much more robust than adding 0.53 points to growth.

Non durable goods are 22.4% of PCE and 15.78% of overall GDP. The sectors contribution to growth rose (fell) to 0.39 (0.28, 0.20) points in the third quarter from 0.31 points in the second quarter and 0.67 points in the first quarter. I suspect that its growth contribution will rebound a bit in the fourth quarter as demand for non durable goods tends to be pretty steady, and its contribution to growth this quarter was below its overall share of the economy.

Overall, the Consumer is doing his and her part in getting the economy rolling again. Unfortunately as we will see later, too much of that consumption is going to things that are made abroad, and not enough to things made here. While the overall level of contribution from the Consumer is still solid, the downward revision is bad news.

Investment tends to be the most volatile part of the economy, and thus is the major reason why the economy either booms or busts, even though it is a relatively small part of the overall economic picture. Overall Gross Domestic Private Investment (GDPI) is just 12.85% (12.87%) of the overall economy. GDPI added 1.80 (1.51, 1.54) growth points in the third quarter, down from 2.88 points in the second quarter and 3.04 points in the first quarter. The decline in contribution from GDPI is disconcerting, although the overall level is still OK. At first glance the big upward revision to GDPI is good news. However when one looks a bit deeper, the picture is a bit more disturbing. While that observation still holds, it is less true with the new numbers than it was with the first look at the data.

Investment is the key to future growth, and as a share of the economy, it is much lower than most other economies. However, not all investment is of the same quality. Fixed investment, particularly investment in equipment and software, is investment that tends to have a positive return on investment, which then drives future growth. But not all investment is fixed.

If companies build up their inventories, that too is counted as investment, and it tends to be of very low quality. If companies are simply adding to store shelves and those goods just sit there, then the investment in inventories will be reversed in later quarters. The inventory cycle is a powerful driver of booms and busts (recessions from 1946 through the early 1980s were mostly due to the inventory cycle, or at least had the inventory cycle as one of the major components). The addition to inventories accounted for almost all the overall contribution from GDPI. Inventory investment added 1.61 (1.30, 1.44) points to growth, up from 0.82 points in the second quarter but down from a whopping 2.64 points in the first quarter. This is very low quality growth, especially coming on several quarters where it has made a significant positive contribution to growth.

The big upward revision here has to be seen as bad news. While the overall growth rate of the economy was revised up, the move away from consumer spending on services towards inventory accumulation marks a significant deterioration in the quality of the growth we saw in the third quarter. This is the fifth straight quarter where inventories have been adding to growth, but that comes after eight quarters in a row where inventories were a drag on overall growth. The big positive contribution from inventories this time around is both disconcerting and was the major reason that overall GDP growth came in higher than I was looking for. I would still look for a much smaller contribution from inventory investment in the fourth quarter, and it would not shock me if it actually proved to be a drag on growth. As inventory growth is low quality, a declining contribution in the fourth quarter would not be the end of the world.

Fixed investment can be broken down into Residential Investment (mostly homebuilding) and non residential (or business) investment. Residential investment has been the major thorn in the side of the economy for a long time now, and the third quarter was no exception. The second quarter was just the second quarter out of the last 16 in which residential investment actually contributed to overall economic growth. In the third quarter, residential investment subtracted 0.75 (0.75, 0.80) points from growth. That is a huge swing from the 0.55 point addition it provided in the second quarter and is a bigger drag than the 0.32 headwind it provided in the first quarter.

Residential investment is now just 2.22% of the overall economy, down from well over 6% of the economy at the peak of the housing bubble. Residential investment has been a drag on GDP growth in 14 of the last 16 quarters. The increase in the second quarter was an anomaly that was mostly due to the home buyer tax credit. We still have a massive overhang of existing homes for sale (including those in foreclosure, and those which are likely to be foreclosed on). Most estimates of the amount of excess housing available today put it at about 2 million housing units.

With that much excess supply, building more houses is at one level simply a massive misallocation of resources. On the other hand, residential investment has always been historically one of the most important locomotives pulling the economy out of recessions. That locomotive is derailed this time around. Residential investment is extremely volatile, and as such tends to “punch far above its weight” when it comes to the overall growth rate of the economy. The lack of residential investment is one of the key reasons this recovery has been so anemic. Eventually population growth and new household formation will absorb the inventory overhang, and residential investment will pick up. That, however, it not going to happen right away.

Recent data on housing starts and new home sales suggest that we might get a positive contribution from residential investment in the fourth quarter, but if so it will be minor. We get the new home sales data for November tomorrow, which will give us much more insight into the potential drag or contribution from housing in the fourth quarter. A small increase from near record lows is expected. Still, just not being a big drag will help overall growth. That bump is almost entirely a function of just how small residential investment has become as a share of the overall economy. The overall bottoming process in residential investment is not over, and it will be a long time before it returns to its historical norm of about 4.4% of the overall economy. However as it does, it will set off some very strong economic growth. That, however, is more likely to be a 2012 story than a 2011 story.

Non-residential, or business investment can also be broken into two major parts: investment in structures, such as new office buildings and strip malls, and investment in equipment and software. Investment in structures subtracted 0.09 (0.15, added 0.10) points from growth in the third quarter, after being a non factor in the second quarter, a 0.01 drag to growth and a 0.53 point drag in the first quarter. This was more like what I expected to see than the original slight contribution to growth. Vacancy rates are still extremely high in almost all areas of the country, and in almost all major types of non-residential real estate. We simply don't need to be putting up a lot of new commercial buildings right now. I would expect it to revert to being a small drag on overall economic growth in the fourth quarter.

Investment in equipment and software (E&S) is what we really want to see to power future growth, and there the news continues to be good, but not quite as good as earlier in the year. E&S investment added 1.02 (1.11 (0.80) points to growth, which is not a bad showing since it is only 7.11% of the overall economy. It is down, however, from a 1.52 point contribution in the second quarter and a 1.24 point contribution in the first quarter. This is the sixth quarter in a row that E&S investment has made a positive contribution to growth. A year ago, investment in E&S was just 6.43% of the overall economy. That increase is highly encouraging, but we need to see it continue to climb as a share of the overall economy. This is probably the highest quality form of growth out there, as it is growth that feeds future growth. The downward revision to the E&S contribution, while not large, was disappointing, and is another indication of a downward revision in the overall quality of the growth, even though the overall rate of GDP growth was revised upwards.

Government spending added 0.79 (0.81, 0.68) points to growth in the third quarter, down from a 0.80 point contribution in the second quarter, but up from being a 0.32 point drag in the first quarter. First I should point out that in the GDP accounts it is only government consumption and investment that is counted as part of G. Transfer payments, such as Social Security, are not included. They tend to show up as part of PCE when Grandma spends her check. What is counted is what the government pays in salaries to its employees (both civilian and military) and its spending on goods, from highways to fighter aircraft. Almost all of the positive contribution came from the Federal government, which added 0.71 (0.71, 0.71) point to growth, down ever so slightly from the 0.72 point contribution in the second quarter, but well above the 0.32 point drag in the first quarter.

Overall Federal Government spending, as defined in the national income statistics, was 8.37% of the economy in the third quarter. Of that 67.32% was spent on Defense, and 32.68% was on Non-Defense spending. Defense spending contributed 0.46 points of growth, up from 0.40 points in the second quarter and just 0.02 points in the first quarter. The non defense contribution was 0.25 points, down from 0.32 in the second quarter but up from a positive contribution of 0.13 points in the first quarter (no revisions to the Federal contributions for either defense or non-defense). I would point out that non-defense federal spending (excluding transfer payments) is just 2.74% of the overall economy, running at an annual rate of just $403.1 billion. Anyone who suggests that it is possible to cure the budget deficit by only cutting non defense spending excluding transfer payments like Medicaid and Social Security is someone who quite simply should stay off of Jeff Foxworthy's show, since they clearly are not smarter than a fifth grader. Social Security has its own dedicated revenue source, and has been running a surplus every year since 1983, and has thus been subsidizing the rest of the Federal Government.

State and local governments were a 0.09 contribution (0.10 point contributor, 0.03 point drag) on the overall economy, up (down) from a 0.08 contribution in the second quarter, but much better than the 0.48 point drag in the first quarter. Frankly, given the severe fiscal problems that most of the States are facing, and since they cannot borrow legally to cover operating deficits, the 0.09 (0.10, -0.03) point contribution (drag) is a major positive surprise. A big part of the ARRA has gone to helping state and local governments avoid having to either cut spending drastically or raise taxes. The ARRA funding is starting to dry up. I would expect that S&L government spending will be a drag on growth in fourth quarter GDP rather than being a contributor as itwas in the third quarter.

The biggest drag by far in the third quarter was net exports, subtracting 1.70 (1.76, 2.01) points from growth. In other words, if we had not had a deterioration in the trade deficit in the third quarter, the economy would have grown at a 4.30% (4.26%, 4.00%) rate rather than a 2.6% (2.5%, 2.0%) rate. That, however, is a substantial improvement over the 3.50 point drag in the second quarter (in other words we would have grown at a 5.2% rate in the second quarter rather than at 1.7% if the trade deficit were unchanged in the second quarter), but is much worse than the 0.31 point drag in the first quarter. To some extent that is overstating the case, as some of those higher imports end up going into inventories, which offsets some of that implied growth if the trade deficit were stabilized.

The problem was all on the import side, as increasing imports subtracted 2.53 (2.52, 2.61) points from growth, down from being an incredible 4.58 point drag in the second quarter, but up from the 1.61 point drag in the first quarter. Of course, that assumes that the foreign goods we bought would have all been made up for by goods produced here in the good old U.S. of A. Since a big part of our trade deficit is due to our addiction to imported oil, that is not something that is going to happen.

However, if we can start to replace imported oil with domestically produced energy we could substantially boost the overall rate of economic growth. While ultimately we would want to do that with renewable sources, such as wind and solar, they mostly produce electricity, and oil is mostly used as a transportation fuel. We do, however, have very abundant supplies of natural gas, and the technology for using natural gas as a transportation fuel is already very well established. We need to take steps NOW to transition to the use of more natural gas as a transportation fuel to replace oil. Ethanol really is not that good of an answer since the production of corn to be made into ethanol for fuel requires using a lot of oil. However, if we can move to ethanol made from things like saw grass, or the corn stalks that are left over from the corn harvests, that would be a major step forward. Biofuels based on algae are also another promising area.

We are actually doing pretty well on the export front, and the recent weakness of the dollar should be a major help going forward. King Dollar is a tyrant and needs to be deposed. It will also help on reducing imports as foreign goods become relatively more expensive and producers fill demand from domestic production. That does not happen overnight however. In the third quarter, increasing exports added 0.82 (0.77, 0.61) points to growth, down from an addition of 1.08 points in the second quarter and 1.30 points in the first quarter. I would expect a bigger positive contribution from exports in the fourth quarter and as we move into 2011, and a smaller drag from exports at the same time. The trade deficit is a far bigger economic problem than is the budget deficit, particularly over the short and intermediate term. While small, the downward revision to the drag from net exports was the one area where the quality of growth actually improved.

While it is nice to see an upward revision to the overall GDP growth rate, I would have to say that this was a bit of a disappointing report. More than all of the upward revision came from the lowest quality source, inventory growth. High quality growth sources such as investment in E&S and consumption of services were revised downwards. Looking out to the fourth quarter, I would not be looking for much growth to be coming from building, either residential or non residential, as we have a big oversupply of both types of buildings in this country. However, even if those parts of the economy are less of a drag in the fourth quarter, that will be a big help to overall growth. Residential investment might even be a small positive contributor in the fourth quarter. Eventually residential investment will pick up, and it is not going to fall all the way to zero, so we might see a little bit of a better performance in the fourth quarter on that front, but it is going to be a long time until we get back to seeing it at a normal share of the overall economy.

With the GOP now in control of the House, look for Federal Government spending to become a drag on growth going forward, but that is probably more of a 2011 story than a fourth quarter story. They have pledged to cut spending in the short term, which is exactly the wrong thing to do; sort of like prescribing barbiturates to a heroin overdose patient. I would also expect that S&L spending will be a drag on growth not a contributor. The tax deal, however, should help add to consumer spending. The cut in the payroll tax will add about $1,000 to the after tax income of the median household. While some households might use some of that to pay down existing debts, and thus accelerate the balance sheet repair job, much of it will be spent. The real wild card for growth in the fourth quarter is going to be the net exports side of things. If we can restrain the trade deficit, we could have some very solid growth in the fourth quarter. That however is a very big IF.

We really need to get growth up to over 3% to make a big dent in putting the millions of unemployed people back to work. The “new” growth of 2.6% is a heck of a lot closer to that goal than the 1.7% growth of the second quarter or the 2.0% original estimate for the third quarter. Normally coming out of recessions, residential investment is a huge positive contributor to growth, not a drag. Considering that that locomotive has been derailed, 2.6% growth is fairly impressive. It is higher than the average growth between the first quarter of 2001 (when Bush took office) through the fourth quarter of 2007 (when the Great Recession started)of 2.4%. If the entire Bush presidency is considered, (1Q01 to 4Q08) growth averaged just 1.8%. So far growth has averaged just 1.3% under Obama.

Of course the economy was in a far worse condition when Obama took office than when Bush took office. Obama's economic policies could not really have had much of an effect on growth in the first quarter of 2009, as the ARRA was not even passed until the quarter was 2/3 over, and he did not even take office until it was almost 1/3 over. If the first quarter of the presidential term is ascribed to the president leaving office, then the average growth under Obama rises to 2.3% and that of Bush falls to just 1.6%. The upcoming austerity of lower spending and higher taxes threatens to erode that progress.

The tax increase I am talking about is not the top end of the Bush tax cuts, as I really don't know if they will be extended or not. It is the expiration of the Making Work Pay tax credit that was part of the ARRA, and which nobody seems to be talking about extending, even though they are far more simulative to the economy than the Bush cuts on the highest incomes. While the incoming Congress seems determined to cut spending in the near term, they are doing their best to make the real problem, the long term structural deficits, worse not better. They want to make the top end of the Bush cuts permanent, and add about $700 billion to the structural deficit over the next decade, and they want to repeal Health Care reform. The non partisan CBO has estimated that the Health Care reform will save nearly $1 Trillion over the next decade.