Strong Growth and an Upbeat Consumer

Numbers released July 27 revealed lean inventories and a solid mix of sales that bodes well for the third quarter

U.S. economic reports on July 27 revealed a solid round of second-quarter gross domestic product data, with lower trend growth for real GDP, a higher average pace of chain price gains, and consumers who remained confident through late July despite the downward nudge in the otherwise still high July confidence reading.

GDP growth accelerated to a 3.4% pace in the second quarter, from 0.6% in the first quarter. Consumption growth slowed to 1.3%, however, from a revised 3.7% rate in the first quarter. Fixed investment grew at a 2.2% rate, following steady subtractions over the prior four quarters. Residential construction fell at a 9.3% rate, which is well below the drag of the past four quarters, and nonresidential investment rose at an 8.1% rate.

Chain price gains moderated to a 2.7% rate from a 4.2% pace in the first quarter, while the core PCE growth rate slowed to 1.4% from a year ago, vs. 2.4% in the first quarter.

Residential Construction Down 9.3%

The report revealed almost exactly what we expected for the second quarter, with a lean pace of inventory accumulation and solid mix of sales that bodes well for third-quarter GDP and the economy overall. The revisions to the quarterly figures for the prior three years revealed an average 0.3% reduction in "real" growth, with a boost to the chain price indexes of about half that amount, leaving a worse mix of data for the Fed for the cycle overall.

Among the components listed in the second-quarter GDP reports, consumption posted exactly the expected 1.3% growth clip, as did fixed investment, at 2.2% growth. The closely watched residential construction figure was also almost a direct hit, with a 9.3% rate of decline, following quarterly swings over the prior three years that were not revised significantly.

Exports underperformed our estimate modestly, with 6.4% growth, but imports were spot-on, with a 2.6% rate of decline. Government spending growth outpaced our guess, with a 4.2% gain, and this overshoot filled the gap of the small export shortfall to leave real GDP growth right in line with our 3.4% forecast.

Some Consolation to the Fed

More generally, we saw a downward revision to trend GDP growth over the past three years of 0.3% that lowered most quarterly growth rates by this amount. There were also associated upward price revisions that were nearly as large. For the revision pattern in the "real" data, the growth path for consumption was revised down the most. The inventory data were revised to exacerbate the recent inventory cycle, with higher figures in 2005 and a bigger correction in 2006, but less dramatic swings in the past few quarters.

As with last year's midyear revision, the bulk of the reduction in "real" trend growth came from an offsetting upward bump to chain price gains. The upward quarterly chain price revisions ended in the third quarter of last year. However, the same figures of 1.7% for the fourth quarter of 2006 and 4.2% for the first quarter of this year are still intact, which may be of some consolation to the Fed.

Yet, more generally, the Fed now faces a lowered bar for what constitutes sustainable "real" growth, and a higher inflation path through this expansion that raises the risks—especially now that the inventory cycle has reversed course and is bringing back the 3% handle to U.S. GDP growth figures.

Downward Nudge in July Sentiment

Also reported July 27, Michigan sentiment was nudged down to 90.4 in the final July print from the 92.4 preliminary reading. But the figure still marks a gain from the 85.3 June final number. The current conditions index slipped to 104.5, after the preliminary number surged to 105.7 from June's final 101.9. The futures outlook index declined to 81.5, vs. the 83.9 preliminary number and 74.7 in June. However, the inflation index edged up to 3.4% for the 1-year ahead outlook, from 3.3% previously.

For the downward nudge in the final July Michigan sentiment figure to 90.4, the level still reflects a big bounce relative to the 85.3 June reading, which parallels the improvement in the weekly ABC/Washington Post figures to a -5 in the most recent week and a likely -8 July average, following the -12 average reading in June. But it bucks the 5.3 point decline seen in the RBC-IPSOS cash index in July, to 76.1, and the 0.9 point drop in the IBD/TIPP index, to 48.2.

We now expect the Conference Board's consumer confidence index to rise to the 105 area, from 103.9 in June, with a recent downgrade due to the stock market adjustment, which may impact that measure.

The various confidence measures moderated through the second quarter from surprisingly high first-quarter levels, as soaring gasoline prices and interest rates took a chunk out of the various measures. Yet we are mostly seeing a confidence bounce as we enter the third quarter that's consistent with a bounce in retail sales in July, following the notable June underperformance. And, with or without the bounce, the confidence figures through 2007 overall have continued to oscillate around levels that are historically solid.

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