I didn’t much like that GDP report from last Friday, showing that the economy expanded at an annual rate of 1.2% in the second quarter. OTEers know my methods: I prefer to smooth out the quarterly noise by looking at year-over-year trends. However, as the figure below shows, that doesn’t help so much. In fact, by that measure real GDP growth has decelerated for each of the last six quarters.
But before getting too wound up, consider the following:
–Real inventories were a big negative last quarter, reducing the top-line number by 1.2 ppts. Inventories are by far the most volatile component of GDP growth, and over the long term tend to balance out around zero. You can see what I mean in the figure below, which looks like an EKG from someone who’s consumed a few too many grande lattes. Why are inventories such a noisy component of GDP? Because unlike all the other components, the underlying inventory measure is already a “delta”—a change, i.e., an inventory build-up or draw-down—so the quarterly change is a “change-in-a-change,” which is invariably more variable and thus indubitably more doubtable in any given quarter.)
–The next question should then be: OK, what’s the trend in real “final sales,” which leaves out the noisy inventory component. That’s averaged a steady 2% over the past four quarters, which is about the economy’s trend growth rate right now, though in the prior four quarters, real final sales grew a point faster.
–The Obama economics team, while they’ve obviously got an angle, provide thoughtful and objective summaries of these reports (you just have to get past the usual “President Obama wakes up every morning thinking about how to boost non-residential fixed investment!”—JK, CEA!). They argue, based on statistical evidence, that a stripped-down version of GDP, comprised of just consumption and investment outside of inventories, provides the best take on where the economy is heading (this breakdown is called “private domestic final purchases” or PDFP). Here’s their take from Friday:
“In recent quarters, weaker foreign demand has dampened business investment, and low oil prices have weighed on energy-related investment, both of which have typically led to slower PDFP growth. In the second quarter, though, these drags on growth were offset by strong consumer spending, resulting in a solid pace of PDFP growth. The gap between PDFP and GDP growth this quarter is more than accounted for by movements in inventory investment. Overall, PDFP rose 2.2 percent over the past four quarters, above the 1.2-percent growth in GDP over the same period.”
So, while I don’t love the deceleration in top-line GDP (Figure 1 above) one bit, I’m not wetting the bed over it, either. The pace of employment and even wage growth, including real wage growth, remains solid. Quarterly GDP is a noisy indicator beset by various factors like inventories that tend to lower the signal-to-noise ratio. The advance report, meaning the first of three releases, is subject to significant revisions. Unusually low energy prices are climbing back a bit and the dollar is weakening, both of which could boost production in coming quarters (net exports were a plus in q2, adding 0.23 ppts to real GDP growth).
If you want to worry about something I have two excellent candidates for you. First, slow productivity growth. I’ve already written a bunch about the deceleration in output-per-hour, and one point I’ve made is that as the job market tightens and labor costs rise, that could create some pressure on firms to squeeze out inefficiencies that they could afford when there was lots of labor market slack (I’ve called this the FEPM: full employment productivity multiplier). We’ll see, but these things turn very slowly.
Second, if, in fact, GDP really does slow down enough to threaten recession, then we’ve got a serious problem. The Fed won’t be able to lower rates much because they’re already quite low. And the fiscal authorities—the Congress—simply can’t be trusted to quickly legislate the needed discretionary spending.
So it will all be about the automatic stabilizers. They’ve proven to be very helpful, for sure—Unemployment Insurance, food stamps, and Medicaid all performed admirably in the last recession (they all benefitted from ramped-up discretionary assistance from the federal gov’t as part of the stimulus). But unless the downturn is very shallow, both of the recessionary-fighting forces may well prove inadequate to the task.
In other words, stay tuned…