Digging into GDP Weakness

 | Jan 27, 2012 | 11:02 AM EST
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The GDP report really wasn't all that strong.

The economy grew 2.8% annually (a sharp advance from the third quarter's 1.8%, but below consensus of 3%), but the biggest contributor was inventories. What gets added to inventories now eventually gets drawn down later, so the inventory contribution -- while it is economic output -- by definition cannot grow forever. Subtract inventories and what you're left with is what people and businesses actually buy or real final sales. And that was a quite weak 0.8%, a big deceleration from the 3.2% pace last quarter.

And remember that the components of long-term potential GDP depend on two basic inputs: growth of the labor force plus productivity gains. Since the labor force grows at roughly 1% annually over the long term and productivity gains tend to be in the 2% (plus or minus) range, the economy needs to grow by about 3% just to keep up with population growth.

For the economy to generate enough jobs to bring down the unemployment rate by one percentage point, the economy needs to grow by 4% to 5% for a full year. That 0.8% underlying growth of final sales is far below that level, though the inventory build story can provide jobs in the manufacturing, transportation and wholesale sectors for as long as companies are restocking shelves. Those sectors accounted for 42% of employment growth last month, entirely consistent with this theme of inventory restocking. As such, job gains in those sectors might not continue into the future.

What we're left with is a circular dilemma. Take a look at consumers' income growth in the fourth quarter. Net of inflation and taxes, real disposable income growth grew by a mere 0.8% at an annualized pace. The only way consumers can spend more than that is by saving less. And we did see that the savings rate fell from 3.9% in the third quarter to 3.7% in the fourth, so that allowed consumer spending in real terms to advance by 2%, up from 1.7% last quarter.  A substantial portion of that spending growth was on autos, and considering the average age of cars on the road is now a very long ten years, there is likely quite a bit of pent-up demand for new cars. Motor vehicle sales alone added 0.81 percentage points to GDP last quarter.

A falling savings rate doesn't mean consumers are actually depleting savings accounts, rather it could be as simple as a household reducing their 401(k) contribution to fund a higher car payment. Since a healthy savings rate, which prevailed for many years prior to the consumer spending binge that started in the past 20 years or so, is 8% to 10% of disposable incomes, it will be hard for an aging population to build savings for retirement at the same time they grow their spending, unless incomes (particularly wages), increase sufficiently to allow them to do so.

Companies simply aren't giving their workers raises. We see this in the employment report. In a separate report, the Bureau of Labor Statistics recently reported that real average hourly earnings for all employees fell 0.9%, seasonally adjusted, from December 2010 to December 2011. And for those who aren't managers or other, more-white-collar employees, real average hourly wages fell by 1.6% during that period. Consumer spending, which accounts for roughly 70% or so of the U.S. economy, can't grow much faster than incomes are increasing.

Now, here's where we get to a more forward-looking view. Real hourly wages fell by 0.9% for all employees in the past 12 months. What happened that allowed spending to increase during that period, besides a falling savings rate?  The 2% payroll tax cut. It has been temporarily extended by Congress for a couple more months, but it is in danger of not being extended for a more prolonged period. If it is allowed to expire, workers will basically get a 2% after-tax pay cut. That can't be good for spending.

But here's the circular logic. If companies are worried that a Europe in recession will hurt global trade for the U.S., they may not plan for expansion.  Exports to Europe are about 3% of U.S. GDP, but we also export to Europe's trading partners as well, so the impact can be felt beyond direct trade to the region. And U.S. companies derive profits from European operations that aren't included in those trade figures. Right now, we haven't seen exports slow yet. In today's GDP report, exports increased by 4.7%. But companies do not look backward when making hiring or investment plans. Coupling worries about Europe with the fact that consumer spending growth is subdued, companies are not planning massive expansions and the lack of pay raises is part of that. Low pay raises beget weaker consumer spending growth, which means companies' revenues, in turn, aren't providing businesses any incentive to give workers salary increases.

We can see companies' intentions to grow (or lack thereof) in today's GDP report. Growth in equipment and software investment by businesses grew by 5.2% at an annual rate, the slowest growth rate in any quarter since the recession ended in 2009.Investment in non-residential structures fell by 7.2%, showing that companies are not investing in new offices, stores or plants. And we also have to consider whether those investments that companies are making are those that boost productivity, lessening the need to hire. We'll find out more in next week's release of the Productivity and Costs report if that was happening in the fourth quarter, but in the meantime the forward-looking metrics of the GDP report do not show much forward-looking momentum, once one delves into the details.

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