Thursday, October 29, 2009

Third Quarter GDP: Cautious Optimism

The third quarter real GDP report that showed an annualized rate of growth of 3.5% has been widely described so far as "stronger-than-expected" and confirming that the recession is indeed over.

The first such assessment is of relatively limited material value (as today's number was only an advance estimate which is is almost always revised, at times appreciably, in the two subsequent months), while the second simply makes something that had already become pretty evident, simply even more so.

The true importance though in the Q3 GDP data lies in their composition, which shows a number of elements coming together to provide some reason for optimism.

It is the combination of a 3.4% rebound in personal spending, a much slower pace of inventory liquidation (making inventories a net contributor to Q3 GDP by 0.9 percentage points), a modest 1.1% gain in residential construction, and a 2.3% increase in government spending that give a preview of an economic recovery with the potential to gain traction in the next couple of quarters. Sure, personal consumption was boosted by a surge in spending on durables ("cash-for-clunkers"), and the gain in government spending reflects the fiscal stimulus program still very much in the pipeline. But somewhat artificial as these two sources of vigor in Q3 may seem, those programs were originally designed precisely to ignite the first sparks of a self-sustaining expansionary dynamic- and they seem to be playing that role well for the time being. That conclusion is reinforced by the fact that the "cash-for-clunkers" program continued to drive inventory levels lower last quarter, therefore setting the stage for a pick up in auto production in the next few quarters.

Even capital spending that had posted alarmingly steep declines in the previous three quarters (-19.5% in Q4 2008, -39.2% in Q1, and -9.6% in Q2), fell by only 2.5%, suggesting that the earlier retrenchment has probably already run its course.

As we have argued before, the various components of GDP and overall pattern of growth can be somewhat muddled around the inflection point of the cycle and this is likely to be validated again in the current quarter, where the unwinding of the "cash-for-clunkers" program could cause personal spending to be flat or even negative. Some of that will be offset by an even stronger contribution to growth from inventories and a small pick up in capital spending.

At this early point, a 2.0-2.5% annualized growth rate for Q4 is not an unreasonable estimate.

Anthony Karydakis

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