GDP Picture, October 27, 2006

October 27, 2006

Housing weakness slows economy

The Bureau of Economic Analysis (BEA) reported today that gross domestic product (GDP) in the U.S. economy grew 1.6% in the 3rd quarter of this year, down from 2.6% in the previous quarter. This is the slowest growth rate since the first quarter of 2003, and this also brings the average for the past year below 3% for the first time since 2003. A large drag on growth in this quarter came again from the weak housing sector, with residential investment falling by over 17%, subtracting 1.1% off total GDP. The housing sector and its persistent weakness continue to grow as macroeconomic concerns: both its growth rate and its share of total GDP have been in recent sharp decline (see the chart below).

The personal savings rate remained negative for the 6th consecutive quarter (-0.5%). Domestic demand growth was essentially unchanged from the previous quarter, rising to 2.1% from 2.0%. A key measure of core prices (the "market-based" deflator for personal consumption expenditures, minus food and energy) slowed in the latest quarter, rising 2.0% compared to 2.6% growth in the previous quarter.

Fast growth in consumption expenditures (especially autos) added 2.13% to growth, while government expenditures (led by state and local spending) added 0.37%. Investment and net exports (the trade balance) subtracted 0.24% and 0.58%, respectively. The trade balance's negative contribution is especially troubling, as the previous quarter's report showed a rare positive contribution from trade. Import growth outpaced export growth 7.8% to 6.5%. Given the already-existing trade deficits, exports will have to grow roughly 50% faster than imports for trade to have a positive effect on GDP growth.

In short, this report describes a weak economy. This quarter's weaknesses (the housing sector and the trade gap) don't look like they will turn around anytime soon, while its strengths (like motor vehicle output, which added 0.72% to GDP, or almost half of the total) are in notoriously volatile sectors that are unlikely to repeat their strong performance in upcoming quarters. Further, when the currently negative savings rate eventually shifts course into positive territory, this will drag on consumption growth and need to be filled in by other components of GDP.

Given the slow growth rate, the continuation of weak housing and trade performance, and the deceleration in core inflation in this report, the argument seems strong for the Federal Reserve to begin cutting interest rates in its next meeting of the open market committee. The past year's growth is well below any serious estimate of the economy's potential, and a key part of the Fed's job has to be maximizing this potential.

Residential Investment: Growth Rate and Share of Total GDP

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