The Last Hurrah?
Posted on October 27, 2023 in Economics
This morning we learned that the economy grew at a 4.9% annualized pace in the third quarter after growing at slightly over 2% in the first half of the year. The growth was driven primarily by three factors: 1) consumer spending grew at a robust pace of 4.0% (think “revenge travel” and Taylor Swift concerts); 2) companies built their inventories to the tune of $105 billion; and 3) government expenditures grew at an outsized rate of 4.6%. These three factors accounted for virtually all of the GDP growth for the quarter, while the combined contributions from business investment, residential investment, and net exports had only a very small impact.
Economists need to figure out if the rapid growth rate in the third quarter is sustainable or anomalous. So, let’s start with the contribution from government expenditures, which contributed about 0.8% to the 4.9% growth rate in the third quarter. Data from the Bureau of Economic Analysis (BEA) going back to 1980 tells us that government expenditures contribute 0.3% to GDP growth in a typical year, far below the 0.8% reported for the third quarter. And given the $2 trillion federal budget deficit racked up over the past year, it could be argued that government spending needs to fall rather than grow in the future. The bond market sure seems to be saying this is the case.
The same BEA data reveals that inventory builds contribute almost no growth in a typical year, making the 1.3% contribution to the third quarter highly unusual. This makes sense as companies have no incentive to grow inventories faster than the rate of inflation over time because it’s an unnecessary expense and a drag on cash flow.
Next, we need to consider if it is realistic to assume that business investment and residential investment will contribute only modestly to growth going forward. Let’s start with residential investment, which subtracted from GDP growth for nine straight quarters before contributing 0.15% to growth in the 3Q23. Residential investment, which includes new housing construction, home improvements, and residential equipment like furnishings and appliances, has been falling for several quarters after a well-publicized spike following COVID’s arrival. And looking ahead, it seems likely that residential investment will remain pressured given the sharp rise in interest rates and its effect on housing affordability. It’s true that a shortage of housing supply should incentivize builders to increase production, but not if building costs keep rising (material inflation, labor shortages) and mortgage rates stay high. And home improvement spending could continue to moderate as well given that demand was pulled forward during COVID and borrowing costs have soared.
As for business investment, the outlook is cloudy as well. After growing at a solid pace in the first half of this year, business investment (with the exception of inventories) ground to a halt in the third quarter. Rising interest rates, tighter lending standards, and an increasingly uncertain economic outlook are starting to negatively impact business sentiment, especially small businesses who are heavily dependent on borrowing. We haven’t seen the concerns reflected in the labor market data yet, but I think that’s coming as factors impacting business confidence continue to mount.
After considering all the above, I think a more normalized GDP growth rate was closer to 3% in the third quarter, with just about all of that growth coming from the 4% growth in consumer spending. Suddenly it becomes clear why economists are so obsessively focused on consumer spending. It usually accounts for 67%-68% in a normal year, but the economy seems much more dependent on it right now! Will the consumer continue his/her free-spending ways in the face of a softer labor market, depleted savings, higher borrowing costs, falling stock and bond prices, and yes, falling home values? I guess it’s possible, but I would be surprised. More likely, consumer spending and the economy at large will both slow meaningfully in the quarters ahead. The outsized growth in the third quarter was just not a good indicator of underlying economic strength. And a heavier dependence on profligate consumer spending is probably not a positive development for an economy already heavily dependent.
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