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Q2 GDP: Not All Bad News

by John B. Hagens

John has been with IPR since 1990, with activity in all of IPR's businesses. Prior to joining IPR, John was senior vice president for the WEFA Group, with responsibility for the company's U.S. economic forecasting service. Before his ten-year stint with Chase Econometrics (and then WEFA), John had jobs as senior economist for the Carter Administration's Council on Wage and Price Stability and for the Social Security Administration, the latter under a Brookings Institution Economic Policy Fellowship awarded while he was an economics professor at Colby College. John holds an undergraduate degree in mathematics and economics from Occidental College and a Ph.D. in economics from Cornell University.

Q2 GDP: Not all bad news

On first blush, the revised estimate of 1.6% growth for second quarter GDP is extremely disheartening. Six months ago, when last year's fourth quarter GDP was reported to have grown more than 5%, many were optimistic that the country had turned the corner on the recession and that we'd begin to see the unemployment rate start its descent from around 10%. Growth slowed to 3.7% in the first quarter of this year and now it has slowed even more. Pundits are now in the process of marking up the odds of a double-dip recession. While the increased pessimism is partially warranted, there are some glimmers of good news - green shoots if you will - in the current GDP numbers.

In May I pointed out that a disproportionate percentage of this recovery's growth has been from inventory accumulation, which is temporary and thus cannot fuel a durable recovery. Inventory accumulation (re-stocking stores, warehouses, factories, etc. with goods after their depletion during the recession) accounted for 56% of growth in the fourth quarter of last year and a whopping 70% of growth in the first quarter of this year. I suggested that we might be being suckered into too much recovery optimism since the growth we were seeing was being abnormally supported by an explicitly temporary source of strength. Well, inventory accumulation not unexpectedly contributed far less punch to the economy in the second quarter, contributing only 0.6 percentage points to growth. However, final private domestic demand (FPDD = consumer spending + fixed investment spending) finally kicked in as the key source of growth. FPDD contributed 3.5 percentage points of growth in Q2 compared with an average 1.3 percentage point contribution since the recovery began last summer. This is decidedly good news.

Secondly, government spending was a source of strength in Q2, contributing 0.9 percentage points to growth. And both federal and state and local spending were positive contributors, reflecting the beneficial effects of last year's stimulus package. Over the previous six months (2009Q4 and 2010q1) weakness in state and local spending more than offset the positive contribution from federal spending. So, while government spending will need to be kept in check over the long haul if the deficit is to be reduced, right now it is a positive, though modest, contributor to growth.

Combining all of these components (final private domestic demand, inventory investment, and government spending - the C+I+G at least I learned about in economics 101) we have a very healthy 5% rate of growth in Q2. Then what happened? In the words of Rod Stewart, every picture tells a story.

GDP growth was ambushed by imports. Exports weakened very slightly, but our huge increase in imports (which is a subtraction from GDP) offset virtually all of the strength in domestic spending (blue bar vs. red bar in the top chart). The tug-of-war is now in place. Will our leaders in Washington refocus on imports as the reason for the lack of job growth and move toward restrictions? Will the Chinese government allow the Renminbi to appreciate, there-by at least potentially making their exports more expensive, partially shifting U.S. demand to domestically produced goods and services? Will current fears of a retrenchment in domestic spending materialize? These fears reflect weakness in recent data on housing and orders and will likely be reinforced by consumers becoming increasingly discouraged by the lack of job growth and by the impact of the stimulus package winding down? These types of questions are almost always present during the first couple of years of a recovery. We had a double-dip recession in the early 1980s and one cannot be ruled out today, but it is too soon to become overly pessimistic. Don't' overlook those green shoots.