– April 29, 2016

Yesterday’s report from the Bureau of Economic Analysis gives the first look at the aggregate state of the economy this year, and it provides reasons for concern.

According to the report, in the first three months of 2016, real gross domestic product, the broadest measure of the economy’s output, grew at a 0.5 percent annual rate. This is the slowest pace of growth in two years (see chart 1).

Yesterday’s report presents what is known as an advance estimate of GDP, which is based on data that are incomplete and subject to further revisions in the coming two months. The revisions could change the picture considerably.

In the past, the size of revisions from the advance to the final (third) estimate of GDP averaged 0.6 percentage points. This suggests that, by the time we have the complete data, the current estimate of 0.5 percent GDP growth in the first quarter of 2016 can easily change to anywhere between -0.1 percent growth (i.e. a reduction in GDP) to 1.1 percent growth.

Whether the future revisions change the overall picture, there are reasons for concern within yesterday’s report. A closer look at the numbers shows that most of the cyclically-sensitive components of aggregate demand decreased in the first quarter of 2016. That is, the types of spending that react to the worsening of economic conditions early and most strongly are falling. These include: consumer spending on durable goods (down 1.6 percent annual rate in the first quarter), business fixed investment in equipment (down 8.6 percent) and structures (down 10.7 percent).

The accumulation of inventories by businesses has slowed to the lowest pace in two years. And even within consumer spending on nondurable goods (a category that is not very sensitive to cyclical factors), spending on things that are discretionary, such as clothing and footwear, has gone down.

All these categories of spending contributed negatively to GDP growth in the first quarter. Another sizeable negative contribution came from exports, which shrunk 2.6 percent (annual rate), likely due to the stronger U.S. dollar and somewhat weaker global growth. A decrease in almost all cyclically sensitive components of spending suggests that the weakness in the economy is spreading.

Still, the overall GDP grew in the first quarter of this year. Two things are fueling this growth: healthy growth in consumer spending on services (up 2.7 percent annual rate), and an increase in residential investment, or housing construction (up 14.8 percent).  

A robust growth in housing, usually a cyclically sensitive component, in the face of a decrease in all other cyclically sensitive spending, may look surprising. But it really isn’t.

The Fed’s policy of exceptionally low interest rates has substantial influence on the housing market. In an extremely low-interest-rate environment, residential investment can continue to grow even when the economy enters a recession. This happened in 2001, when U.S. economy went through a mild recession, but the housing sector never knew it, fueled by the then-unprecedented extra-low interest rates maintained by the Fed. Today, the Fed maintains interest rates much below what we’ve seen in 2001. Thus, rising residential investment and housing construction is no surprise, but it might not reflect the strength of the consumer as much as it reflects the low interest rates.

There is one indication of the strength of consumers in yesterday’s report. The real disposable personal income, the money people have available after all taxes are paid and any transfers received, continues to grow at a decent rate. In the first quarter of 2016 it grew at a 2.9 percent annual rate, and was 2.8 percent higher than a year ago, a faster pace of growth than that of GDP.

This means that consumers do have income to spend. They just seem to be reluctant to do so – the saving rate ticked up to 5.2 percent of disposable income, from 5 percent in the last quarter of 2015. In general, the saving rate has been elevated in this business-cycle expansion compared to the previous one (see chart 2), which might explain the subdued growth in GDP. A higher saving rate is good for each individual’s financial security, but if most consumers decide to save more, it translates into restrained spending for the overall economy.

The revised GDP estimates that will come out in the next two months will give us a better idea of whether this growth slowdown is temporary or not. One thing is certain, however – the growth of U.S. economy seems to be set on a slower trend for a while. When the recession ended in 2009, the economy’s growth never returned to the pace seen in other expansions. Since 2009, the U.S. economy grew, on average, around 2 percent per year (see chart 1 above). This is far below the average growth in past business-cycle expansions, which reached around 4 percent. The current slowdown may be temporary, but the unimpressive trend growth of about 2 percent per year seems to be here to stay.

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Polina Vlasenko, PhD

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