U.S.: A Speedup Is Just Beyond Those Sluggish Numbers
So much for the midcycle slowdown. After four years of solid growth, many analysts had expected the economy to cool abruptly this year, as the Federal Reserve's interest rate hikes took hold. The last time that happened was in 1995, following the Fed's efforts to prevent the economy from overheating. To some extent that scenario has played out, but maybe not for the reasons analysts thought it would. This year's pullback appears to have had more to do with the runup in energy prices than the dampening effects of Fed policy. In fact, with the energy situation turning around, the midcycle slowdown, such as it was, is quickly turning into a mid-cycle acceleration.
When the Bureau of Economic Analysis delivers its first look at third-quarter gross domestic product on Oct. 27, expect a tepid-looking headline number for overall economic growth, perhaps even less than the second quarter's mild 2.6% advance. But for the fourth quarter and early 2007, at least, the pace is set to quicken as several drags on the economy begin to lift, or, in the case of housing, become a bit less of a burden.
The GDP report will highlight the two biggest curbs on the economy this year: the housing slump and the surge in energy costs. But while the Fed holds some of the responsibility for the weak housing sector, it has none for the depressing effect of $77-per-barrel oil on business confidence or $3-per-gallon gasoline on household budgets. And the turnarounds there are helping to restore a livelier economic pace.
SIGNS OF A PICKUP are emerging. Recent stock market gains show investors sense a change in the air, a feeling that stock prices already contain all the bad news on the economy. Small businesses voiced greater optimism in September, and consumer confidence rebounded strongly in October. Households seem especially thrilled by lower gas prices, as the plunge in overall inflation boosts the buying power of their paychecks.
Meanwhile, it's beginning to look like the housing slump is not the monster waiting to devour the economy that all the scare stories have made it out to be. Residential investment appears to have subtracted about a percentage point from overall economic growth in the third quarter, a heavy blow from a sector making up only 6% of GDP. For the current quarter, look for more of the same. Additional cutbacks in new construction are still needed to shrink builders' inventories, and more price weakness will show up in many existing-home markets as buyer-seller standoffs continue.
But housing's biggest blow to the economy is very likely occurring right now. Builders' sentiments about market conditions, although at an extremely low level, may have hit bottom in September. They edged up a tick in October for the first time in a year, according to the National Association of Home Builders. Housing starts in September also posted a surprise gain.
THE IMPORTANT POINT for the future is this: After nearly a year of this downward pressure, any housing-related fallout on consumer spending has yet to show up. That's because households have had solid support from strong labor markets, an accelerating pace of income growth, and steady additions to wealth.
Now, falling gas prices are adding to the forces already in place. Indeed, consumer spending is accelerating, not slowing down. It rose at a 2.6% annual rate in the second quarter. The third-quarter rise, which will show up in the GDP report, appears to have been in the 3%-to-3.5% range, and the advance this quarter will most likely be even larger.
That's the implication from September reports on retail sales and the consumer price index. Retail buying fell 0.4% from August, but that decline reflected a record 9.3% drop in the dollars consumers surrendered at gas stations because of the sharp retreat in pump prices. Excluding gas, spending on everything else increased a strong 0.6%, including sizable gains at department and clothing stores. The big advance means overall household outlays headed into the fourth quarter with strong upward momentum.
The September CPI shows why that forward thrust will continue. Reflecting a 7.2% drop in energy prices from August, coming mainly from a 13.5% plunge in gas prices, the overall CPI fell 0.5% last month. In only the past three months, the 12-month inflation rate has dropped from 4.3% to 2.1%. That's about 2 percentage points automatically tacked on to the purchasing power of household incomes--sort of like spending $100 but getting an additional $2 worth of goods and services for free.
Retail gas prices in mid-October are already down an additional 12% from their September average, setting up the possibility of another decline in the October CPI. This could mean an overall fourth-quarter CPI no higher, or slightly below, the third-quarter level. That's important in the GDP math for real consumer spending. At that level, inflation will be subtracting almost nothing from the dollars consumers shell out in the fourth quarter, which could result in a bang-up contribution to this quarter's economic growth.
THE SPRING AND SUMMER POP in gas prices has affected the economy's performance in other ways--including slower inventory growth and higher imports--that will show up in the third-quarter GDP report. But these weights also will be lifting in the months ahead.
Most notably, the gas-price jump added to the already heavy burdens on the U.S. auto industry. As consumers shifted from gas-guzzlers to fuel-sippers, buyers turned increasingly to imports for the cars they wanted. Auto imports over the past six months have run 8.3% ahead of the same period in 2005, when they were up only 1.5% from 2004. Burdened by weaker demand and ballooning inventories, Detroit cut light vehicle production by 22%, measured at an annual rate, in the third quarter.
Coming on top of the losses from home construction, the auto cutbacks have had a major impact on the health of overall manufacturing, as the effects have worked through the industry's long supply chain. Manufacturing production fell 0.3% in September, and growth for the third quarter slowed to a 4.3% annual rate from the second quarter. Factory output has cooled progressively in each quarter this year, but excluding motor vehicles and parts, production in the third quarter grew at the same 5.4% rate as it did in the second quarter. Moreover, Detroit's output schedules for the current quarter suggest the deepest part of its production cuts is over.
What will rejuvenate factory activity in coming months--and propel the overall economy at a faster clip--is continued strength in overall demand. When the GDP report comes out, don't obsess over the lukewarm top-line number for economic growth. Look at what's happening in three categories: consumer spending, business outlays for new equipment and buildings, and exports. Each of those sectors will have grown faster than in the second quarter. Those are the figures that will tell you overall growth is set to pick up.
By James C. Cooper