GDP, the Labor Market, and the Fed

As if this year hasn’t been odd enough, the advance GDP report for the second quarter presented a strange picture. The headline figure (a 1.2% annual rate) was weaker than expected, due to a sharp slowing in inventories (in fact, inventories actually declined for the first time since 3Q11). Final sales, which excludes the change in inventories, rose at a 2.6% pace. Consumer spending rose sharply, but just about everything else was soft. Attention now turns to the July Employment Report, which is subject to its own special quirks.

Inventories are what economists call “a stock,” or a quantity. GDP is a flow, output per unit time. The change in inventories contributes to the level of GDP. The change in the change in inventories contributes to GDP growth. Thus, if inventories are rising slower than in the previous quarter, that change subtracts from GDP growth. Inventories not only slowed in 2Q16, they contracted. That’s unusual. It’s often hard to tell what’s behind slower inventory growth. Firms may be more pessimistic about future sales, or they may have been surprised by stronger-than-expected demand. In this case, it may have been a combination of both. At a 4.2% annual rate, inflation-adjusted consumer spending growth was very strong. At the same time, we know that a lot of firms are worried about the global economic outlook and election-year uncertainty has likely contributed to softness in capital spending. Still, barring significant economic weakness, inventory growth is likely to pick up in the second half of the year (adding to GDP growth).

The quarter’s strength in consumer spending likely reflects problems adjusting for the early Easter (which likely shifted activity from 1Q16 to 2Q16). Still, when averaged together, consumer spending (which accounts for 70% of GDP) rose at a 2.9% annual rate in the first half of the year. Consumer fundamentals (job growth, low gasoline prices) have been supportive and should remain so in the near term.

Unfortunately, just about everything else that goes into GDP was soft in 2Q16. Residential fixed investment pulled back a bit. Government consumption and investment slipped (reflecting a dip in defense spending). Foreign trade added a little to the headline growth figure, as exports edged up and inventories declined (inventories have a minus sign in the GDP calculation).

A bigger concern is the third consecutive decline in business fixed investment. Mining structures (which includes oil and gas well drilling) continued to contract. However, beyond energy, capital spending has been soft. This isn’t recessionary. Capital spending falls more sharply during economic downturns, but the slowdown is apparent on a global basis, not just in the U.S. More worrisome is the fact that interest rates are so low. If you can’t borrow money at these rates and find something useful to invest in, what does that say about the prospects for the global economy? Hopefully, this is temporary. Policymakers should focus on keeping consumer spending going. Eventually, business investment will take care of itself.

Yet, the prospects for growth are a lot different than what we grew up with. Growth in the working-age population was a lot more robust in the second half of the 20th century (reflecting the baby boom and increased female labor force participation). The working-age population is expected to grow at about 0.5% per year over the next 10 years. It’s already negative in many advanced economies and has been declining in China since 2011. Thus, unless we see a sharp rise in immigration or a strong pickup in productivity growth, the upside for GDP growth is likely to be limited (2% may be the best it gets).

The demographics may not give the Fed much pause, as it implies that the job market will tighten sooner than it would have otherwise. However, the Federal Open Market Committee has plenty of time to wait before resuming policy normalization, even if the new normal includes a 2% GDP bogie.

© Raymond James

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