In the first quarter, the economy grew at an annual rate of 1.8%, down from 3.1% in the fourth quarter, and from the 2.6% pace in the third quarter. The growth rate was slightly above consensus expectations of 1.7%. Also, the quality of the growth was weaker than in the fourth quarter, but not awful. The first graph (from this source) shows the history of GDP growth.
So how did we get to the 1.8% overall growth? What parts of the economy were growing and thus adding to growth and which parts were acting as a drag? Since the different parts of the economy are of very different sizes, and some tend to be relatively stable while others can be very volatile, I will focus on the contributions to growth. In other words, growth points, not the percentage growth rates.
After all, a small percentage change in a very big part of the economy can have more impact than a big percentage change in a small part of the economy. To do this I will follow the familiar Y = C + I + G + (X – M) framework, where Y = GDP, C= Consumption, I = Investment, G= Government, X = exports and M = imports.
Personal Consumption Expenditures
The biggest part of the economy by far is the Consumer, or consumption, or to be more specific, Personal Consumption Expenditures (PCE). It represented 71.2% of the overall economy in the fourth quarter, and was the biggest growth driver. PCE contributed 1.91 growth points, down from 2.79 points in the fourth quarter but up from 1.67 points in the third quarter.
The increasing contribution to growth from C is generally a good thing, at least in the short term. Over the long term, our economy is already weighted far too much towards C, and that contribution has been rising over the years. Back in the 1960’s it represented more like 64% of the overall economy.
Our consumption share is also far higher than most other economies in the world. Still, we need consumers to be opening their wallets for the economy to grow, at least in the short term. This is high-quality growth, and is very welcome in the current environment.
Goods vs. Services
Consumption can be broken down into two main categories, goods and services. Goods can be further broken down into durable goods, which tend to be big ticket items that will last more than 3 years and Non-Durable goods, which tend to be consumed right away. (For some reason clothing is categorized as a non-durable good. Clearly the people making those decisions have never looked into my closet.)
Services are by far the biggest part of consumption, at 65.96% of PCE and 46.96% of overall GDP. It chipped in 0.70 growth points, up slightly from contributing 0.70 points in the fourth quarter and from a net contribution of 0.74 points in the third quarter.
This solid increase is very encouraging. Services tend to be “produced” domestically, not in China, and also tend to be more labor intensive than goods producing jobs. Normally, demand for services is more stable than demand for goods, especially durable goods.
Durable vs. Non-Durable Goods
Within the consumption of goods, consumption of non-durable goods is about twice as large as the consumption of durable goods. However, since people can defer purchase of durable goods like an auto from Ford (F) more easily than they can defer purchase of a box of Corn Flakes from Kellogg’s (K), durable goods demand is very volatile. As a result, durable goods tend to “punch above their weight” in determining if the economy is booming or slumping.
Durable goods consumption added 0.78 points to growth, down sharply from an addition of 1.45 points in the fourth quarter but up from 0.54 points in the third quarter. While that contribution is not bad, the sharp slowdown is a bit disheartening. The sector is only 10.88% of PCE and 7.75% of overall GDP, yet it contributed 43.33% of the overall GDP growth in the quarter. Early in recoveries it tends to have a bigger positive impact, but it also has a big negative impact when the economy falls into recession.
Non-durable goods are 23.15% of PCE and 16.48% of overall GDP. The sector’s contribution to growth fell to 0.34 points in the first quarter from 0.65 points in the fourth quarter and 0.39 points in the third quarter. For a “Steady Eddie” part of the economy, this is nice solid, and importantly, sustainable level of contribution to growth.
Overall, the Consumer is doing his and her part in getting the economy rolling again. The strong contribution from the consumer service sector is encouraging. All three parts made solid contributions to growth, though goods much less so than in the fourth quarter.
While over the long term we can worry that far too much of the overall U.S. economy is dedicated to consumption and not enough to investment and exports, for right now we want to see the Consumer alive and kicking. Without a doubt he was in the first quarter, but not kicking as hard as at the end of last year.
Investment
Investment tends to be the most volatile part of the economy, and thus is the major reason why the economy either booms or busts, even though it is a relatively small part of the overall economic picture. Overall Gross Domestic Private Investment (GDPI) is just 12.42% of the overall economy. Overall GDPI added 1.01 growth points in the fourth quarter, a sharp reversal from subtracting 2.61 points in the fourth quarter but down from the 1.80 point contribution in the third quarter.
Investment is the key to future growth, but as a share of the economy it is much lower than most other economies. However, not all investment is of the same quality. Fixed investment, particularly investment in equipment and software, is investment that tends to have a positive return on investment and which then drives future growth.
But not all investment is fixed. If companies build up their inventories, that too is counted as investment, and it tends to be of very low quality. If companies are simply adding to store shelves, and those goods just sit there, then the investment in inventories will be reversed in later quarters.
This is exactly the dynamic we are seeing in the first quarter numbers. The inventory cycle is a powerful driver of booms and busts; recessions from 1946 through the early 1980’s were mostly due to the inventory cycle, or at least had the inventory cycle as one of the major components.
The increase in inventories accounted for most than all the overall increase from GDPI. Inventory investment added 0.93 points from growth in the fourth quarter. That is a sharp reversal from the fourth quarter, when lower inventories subtracted 3.42% from the overall growth.
In the third quarter, inventories added 1.61 points to growth. In other words, in the first quarter, 51.7% (0.93/1.8) of the total growth came from adding goods to the shelves, not from people actually buying the stuff on the shelves. This is very low quality growth, especially when it happens for several quarters in a row, and we had five of them where inventories were a big positive player in providing growth. Then again, those came after eight quarters in a row where inventories were a drag on overall growth.
Clearly inventories can have a big influence on overall growth, but it tends to be very low quality growth. There does, however, seem to be somewhat of an inverse correlation with net exports, which I discuss below. The contribution from inventories was large relative to overall growth, but not particularly big in absolute terms. In other words, not so big as it is likely to turn negative in the second quarter.
If inventories had just been a non-factor, the economy would have been crawling along at a 0.9% growth rate — down from an awesome 6.5% growth rate in thr fourth quarter. The pace of growth ex-inventories is roughly similar to what we were running in the third quarter (1.0%) and in the second quarter of last year (0.9%).
Residential vs. Non-Residential Investment
Fixed investment can be broken down into Residential Investment (mostly homebuilding) and non-residential (or business) investment. Residential investment has been the major thorn in the side of the economy for a long time now. That changed a bit in the fourth quarter, and we appear to be slowly forming a bottom in residential investment, it being up in two of the last three quarters.
In the fourth quarter, residential investment added just 0.07 points to growth, but that is a big swing from the 0.75 point drag in the third quarter. In the second quarter, fueled by the first-time buyer tax credit, Residential Investment added 0.55 points to growth, but that was a big exception to the recent trend. The first quarter was back to more “normal” form, subtracting 0.07% from overall growth.
Residential investment is now just 2.21% of the overall economy, down from well over 6% of the economy at the peak of the housing bubble. Normal is about 4.4% of the economy. While the levels are still just plain awful, they have shrunk so much that it is hard for it to have that much of an effect on the overall rate of growth.
Residential investment has been a drag on GDP growth in 15 of the last 18 quarters. We still have a massive overhang of existing homes for sale (including those in foreclosure, and those which are likely to be foreclosed on). Most estimates of the amount of excess housing available today put it at about 1.6 million housing units.
With that much excess supply, building more houses is at one level simply a massive misallocation of resources. On the other hand, residential investment has always been historically one of the most important locomotives pulling the economy out of recessions. That locomotive is derailed this time around.
Residential investment is extremely volatile, and as such tends to “punch far above its weight” when it comes to the overall growth rate of the economy. The lack of residential investment is one of the key reasons that the recovery so far has been so anemic. Eventually population growth and new household formation will absorb the inventory overhang, and residential investment will pick up. That, however, it not going to happen right away.
Still, starting from such a low level, it seems likely that Residential Investment is likely to be a positive contributor to growth in 2011. Not a very big one — that is more likely a 2012 story — but simply by not being a major drag on the economy will be a major turn for the better. That bump is almost entirely a function of just how small residential investment has become as a share of the overall economy.
The overall bottoming process in residential investment is not over, and it will be a long time before it returns to its historical norm of about 4.4% of the overall economy. However, as it does, it will set off some very strong economic growth. We are now at an all-time low for residential investment as a share of the economy, as shown in the next graph (also from this source).
Note how at the end of every previous recession, residential investment increased sharply as a share of GDP, in effect leading the economy out of the recession, but how it has persistently declined this time around. That is THE key reason that this recovery seems so sluggish.
Structures vs. E&S
Non-residential or business investment can also be broken into two major parts: investment in structures, such as new office buildings and strip malls, and investment in equipment and software (E&S). Investment in structures subtracted 0.63 points from growth in the first quarter. That is a very big negative swing from a contribution of 0.19 points in the fourth quarter.
I have to say the magnitude of the drop this quarter was a bit of a surprise, but not the direction. Vacancy rates are still extremely high in almost all areas of the country, and in almost all major types of non-residential real estate. We simply don’t need to be putting up a lot of new commercial buildings right now.
On the other hand, as the economy improves, we are starting to see some signs of those vacancies being absorbed, and prices for commercial real estate seem to be starting to firm up. The best leading indicator of future investment in non-residential structures is the amount of activity among architects.
That index has come back to being around flat in recent months after being deeply negative for most of 2009 and 2010. Later in the year and into 2012, it is more likely to be a significant positive force for economic growth, but not yet.
Investment in E&S is what we really want to see to power future growth, and there the news continues to be good. E&S investment added 0.80 points to growth, which is not a bad showing since it is only 7.38% of the overall economy. That is a nice improvement over the 0.54 contribution in the fourth quarter but down from the 1.02 point boost in the third quarter, and a 1.52 point contribution in the second quarter.
This is the eighth quarter in a row that E&S investment has made a positive contribution to growth. A year ago, investment in E&S was just 6.71% of the overall economy. That increase is highly encouraging, but we need to see it continue it climb as a share of the overall economy. This is probably the highest quality form of growth out there, as it is growth that feeds future growth. I would prefer to see even more growth coming from this front, but a 0.80 point contribution is still extremely strong.
The next graph (also from this source) shows the contributions to growth from the three components of fixed investment on a rolling four quarter average basis. Note the very sharp rebound in E&S spending, back up to the levels of the late 1990’s, relative to the persistent drag from investment in structures, both residential and non residential.
Government Spending
Government spending subtracted 1.09 points to growth in the fourth quarter, down from a 0.34 point drag in the fourth quarter, and a 0.79 point addition in the third quarter. I should point out that in the GDP accounts it is only government consumption and investment that is counted as part of “G.” Transfer payments such as Social Security are not included — they tend to show up as part of PCE when Grandma spends her check.
What is counted is what the government pays in salaries to its employees (both civilian and military) and its spending on goods, from highways to fighter aircraft. The negative contribution from government this quarter just goes to show that a concretionary fiscal policy is, well concretionary. There is no such thing as growth-inducing austerity. The zeal to cut government spending NOW — and hard — is having an adverse effect on the economy, and as the budget cuts go further, the drag from “G” is only going to get bigger.
The Federal government was big factor in the first quarter growth slowdown, subtracting 0.68 points from growth. It was essentially a non-factor in the fourth quarter, being just a 0.02% drag. That is down from adding 0.71 points to growth in the third quarter and from the 0.72 point contribution in the second quarter.
Overall Federal Government spending, as defined in the national income statistics, was 8.15% of the economy in the first quarter, down from 8.33% in the fourth quarter. Of that, 66.5% was spent on Defense, and 33.5% was on Non-Defense spending. Put another way, just 2.73% of the overall economy is non-defense federal spending (excluding transfer payments) and 5.42% of GDP is spent on Defense.
Defense spending subtracted 0.68 points from growth, a much bigger drag than the 0.12 point drag in the fourth quarter. It contributed of 0.46 points in the third quarter and 0.40 points in the second quarter. All things considered, if I had to pick one area to be a drag on growth it would be military spending. While making and dropping bombs does add to the economy in the national income statistics, it does not exactly build the economy or make people better off. That is not saying that it is not needed, but the “less needed” the better.
I suspect that the sharp drop in the first quarter is a bit of an aberration though, and much of the spending will be made up in the second and third quarters. We are still involved in three wars (ok, 2
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