Recent data reports have added little color to the economic outlook, but that may change soon enough. The advance GDP report should show the economy advancing at a moderate pace, but results are likely to remain mixed across sectors. Fed officials were close to raising rates in September, but recent figures probably haven’t been compelling enough to force action at the November 1-2 policy meeting. The employment report will be subject to the usual uncertainties, but job growth has slowed, if only reflecting tighter job market conditions.
Investors place far too much significance in the headline GDP growth figure. This is the advance estimate (arriving Thursday) and will be subject to large revisions. However, the story ought not to change much. Consumer spending growth (roughly 70% of GDP) was likely moderate – slower than the second quarter’s blistering 4.4% pace, but better than the first quarter’s 1.6%. Business fixed investment and residential homebuilding are likely to have been soft. A slowing trend in inventory growth subtracted significantly from headline GDP growth in recent quarters, making the economy appear weaker than it really is. An inventory rebuild was expected to fuel stronger GDP growth in 3Q16, but now that contribution appears likely to have been much more modest. Foreign trade ought to add, largely reflecting a surge in agricultural exports.
Job growth was especially strong in 2014 and 2015, recovering more of the slack generated in the financial crisis. However, the trend appears to have slowed this year. That likely reflects tighter labor market conditions. Late in the job market recovery, tight conditions typically lead to higher wages and many of those on the sidelines (out of work, but not officially counted as “unemployed”) will return to the workforce. Wage growth is still moderate, but higher than in recent years, and labor force participation has begun to rise.
The November 1-2 meeting of the Federal Open Market Committee will be a “live” meeting, meaning that officials will consider a rate hike. Internal pressure to raise rates has been building – in mid-September, 9 of the 12 district banks wanted an increase in the discount rate (the rate the Fed charges banks for short-term borrowing), but that was denied by the Fed’s governors. It’s widely believed that the FOMC will refrain from raising rates, so as to stay out of the election. Others believe that the Fed can only hike when there is a press conference. Both of these arguments are wrong. Rather, consider why the FOMC refrained from raising rates in September. It wanted to wait for more evidence of progress towards the Fed’s goals (maximum sustainable employment and 2% inflation in the PCE Price Index) and the risks of a policy error are not symmetric (it would be harder to correct course if the Fed moves too rapidly). These factors have not changed much since mid-September.
What else? Oh, yeah. The election. Alone, a president can’t do a lot on the economy. She needs support from Congress. The real issue is now the down ballot contests.
Nonfarm payrolls rose at a moderately strong pace in the initial estimate for September, a bit less than expected, but well within the usual range of uncertainty. The pace of job growth appears to have slowed this year, but we’re still adding jobs beyond a long-term sustainable pace.
With the start of the school year and the end of the summer travel period, seasonality is a major issue in September. One should take the reported the data with a grain of salt. That said, the nonfarm payroll figure (+156,000) was not far off the mark. The impact of noisy data can be reduced by looking at averages. Payroll gains were moderately strong in 3Q16, slower than last year, but we only need about 100,000 per month to be consistent with population growth.
The mild uptick in the unemployment rate (to 5.0%) reflected an increase in labor force participation. There is a long-term downtrend in participation, but we may have recovered much of the cyclical decline, at least for the key age cohort (25-54 yrs.).
Average hourly earnings rose 2.6% from a year ago, still moderate by historical standards, but better than in recent years. Wage gains have varied across industries.
While nominal wage growth has picked up, energy prices have stopped falling, leaving a smaller year-over-year gain in real earnings (and less firepower for consumer spending growth).
Fed officials will look at these data, but each may come away with a different conclusion. The job market is getting tighter, but the pace of improvement appears to have slowed relative to the last couple of years. Slower job growth may be due to tighter labor market conditions. If so, wage growth ought to be picking up. Average hourly earnings are rising at a faster pace relative to the last couple of years (2% per year in 2014 and 2015), but that’s still moderate by historical standards.
Two more job reports arrive before the mid-December Fed policy meeting. We should see evidence of further tightening, but improvement that is not too rapid, consistent with another modest removal of policy accommodation. Of course, there are a lot of other things for the Fed to worry about.
Investors place far too much emphasis on the GDP figures. However, digging into the components suggests a less optimistic (not pessimistic) outlook for growth in the near term.
Real GDP rose at a 1.4% annual rate in the 3rd estimate for 2Q16, held back by a slower pace of inventory growth. Recall that GDP is a flow ($/time), while inventories are a stock ($). The change in inventories ($/time) contributes to the level of GDP, which means that the change in the change in inventories contributes to GDP growth. In other words, a slowdown in inventory growth subtracts from GDP growth. That was the case in each of the last four quarters. Real GDP rose 1.3% in the four quarters ending 2Q16, but would have risen 2.6% -- twice as fast – if not for the inventory slowdown. When inventories slow, it’s often unclear why. Firms may be more cautious about future sales or demand may have exceed expectations. Lean inventories (relative to sales) normally bode well for future production as inventories are rebuilt. A large inventory rebuild was expected to propel 3Q16 GDP growth to 3% or more. We now have two months of sketchy inventory figures for the third quarter. Price changes make it difficult to estimate what has happened in real terms, but it looks as if the inventory rebuild will be more moderate than anticipated. Perhaps the inventory rebuild will be shifted into the fourth quarter or into early 2017, but it seems likely that the level of inventories has adjusted to an expected slower long-term trend in overall growth, and will not add as much to GDP as was expected.
Consumer spending accounts for about 69% of GDP. We now have figures for July and August, which suggest some loss of momentum. The household sector fundamentals remain sound. Job growth has remained strong (not quite as robust as in the last two years, but that’s to be expected as labor market slack is taken up). The Conference Board’s Consumer Confidence Index has broken out of its recent range and is back to pre-recession levels. While consumers don’t spend confidence, surveys show that people are more optimistic about current job availability (although they remain generally a bit pessimistic about future jobs). Spending on autos and other consumer durables softened in August and anecdotal reports suggest further weakness in September. Big-ticket purchases are sensitive to expectations. Election-year uncertainty may be a restraining factor. The budgets of middle-class households may be strained by higher rents and healthcare costs. However, spending is normally lumpy, bunching up and slowing down around a longer-term trend. Spending numbers through August suggest a softer quarter than was anticipated earlier. More importantly, the trend appears likely to carry though to 4Q16 (that’s simply the way the monthly-to-quarterly arithmetic works). That doesn’t mean that we are in danger of falling into a recession, but it does imply an adjustment to expectations.
Other GDP components have appeared mixed. Business fixed investment was revised higher in the 3rd estimate for 3Q16, but that largely reflected strength in intellectual property products. Spending on structures and equipment continued to weaken. Shipments of capital goods were weak in the first two months of 3Q16, but orders have been improving (there’s hope). The contraction in energy exploration has ended. We don’t anticipate a sharp rebound in oil and gas well drilling, but an end of the decline should be enough (that is, energy is no longer a subtraction from GDP growth).
Putting the components together suggests that GDP growth is likely to be in the 2.0-2.5% range, lower than the 3+% expectations of a few weeks ago. The outlook for 4Q16 has come down as well, to about a 1.5-2.0% annual rate. That’s not terrible, but it is consistent with a lower trend rate of growth in the near term (slower labor force growth combined with a sluggish rate of productivity growth).
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