Economy sees strong growth in the face of housing implosion

October 31, 2007

The Bureau of Economic Analysis reported today that real (inflation-adjusted) gross domestic product (GDP) grew 3.9% in the third quarter of 2007, essentially unchanged from the second quarter's 3.8% growth.

The strongest contributions to this growth came from personal consumption expenditures (PCE), which added 2.1% to GDP growth this quarter, and from net exports, which contributed 0.9%. Government expenditures contributed 0.7% to GDP growth, while investment contributed only 0.1%.

A continuing surprise is the resilience of personal consumption. Given the housing downturn (which should be expected to reduce consumption both by making homeowners feel less wealthy and by curtailing opportunities for consumption through mortgage equity withdrawals), many have worried about continued growth in this area. There is no evidence in this report that consumers are pulling back, for this or any other reason. While encouraging, it seems premature to declare that reduced housing wealth has fully impacted U.S. consumers yet.

The strong personal consumption growth was accompanied by a small up-tick in personal savings (0.8% of disposable personal income, compared to 0.6% in the previous quarter).

Continuing weakness from the housing sector, however, was seen in residential investment, which shrank by 20% in the third quarter, following a 12% decline in the previous quarter. This represents the seventh straight quarter that residential investment has shrunk.

Inflation in the "market-based core" PCE deflator (excluding food and energy) was tame in the third quarter, up only 1.5%. Inflation in the deflator for gross domestic purchases, which measures prices paid by U.S. residents (including for food and energy), was 1.6%. These levels should not present an inflation scare for the Fed.

A second consecutive quarter of net exports contributing to overall growth is welcome news, not only because net exports have been a consistent drag on GDP throughout most of the current recovery, but also because they have the potential to counter-act some of residential investment's drag on growth. The sustained fall in the dollar against many important U.S. trading partners seems to be paying dividends in the form of robust export growth. It should be noted, however, that many of the countries with which the U.S. runs large deficits (especially China) have adopted the policy of managing the value of their own currency to keep it stable vis-a-vis the dollar. Until these countries allow their currencies to rise relative to the dollar, export growth will be like an engine not firing on all cylinders, as it will be concentrated only on countries whose currencies have revalued.

Given the persistence of residential investment's decline, it seems worth asking whether its drag on GDP is approaching any kind of limit. The figure below shows that residential investment has lost 1.8% measured as a share of GDP since its most recent peak in the fourth quarter of 2005. This loss is not atypical. The last two historical episodes that saw at least seven straight quarters of falling residential investment experienced declines of roughly the same magnitude measured as a share of the peak value.

(figure)

Further, the current level of residential investment as a share of GDP is nowhere near a historic low—in fact, it remains right around the post-1979 average (4.5% vs. 4.6%). Given that housing inventory by most measures remains at an all-time high, there is very little evidence that the decline in residential investment as a share of the overall economy is anywhere near bottoming out.

Another important bit of information regarding the effect of the housing market on growth concerns the increase of non-residential investment. Again, in the past two historical episodes during which residential investment shrank for at least seven quarters straight, non-residential investment quickly followed the downward trajectory and exerted a strong drag on growth for the next 12 quarters (knocking, on average, 0.12% off GDP growth in each of the following 12 quarters). To date, non-residential investment in the current downturn has continued to grow, and has only decelerated a bit so far. This has been good luck for the American economy, but it remains a worry for the future.

These worries aside, today's GDP report is mildly encouraging. Net exports continue to contribute strongly to growth, which is a key ingredient in sustaining the U.S. economy through the deflating housing market.

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