January 31, 2007 (GDP Byte)
By Dean Baker
Savings were negative for the second consecutive year.
The economy grew at a surprisingly strong 3.5 percent annual rate in the 4th quarter, driven primarily by strong consumption growth and an improvement in the trade balance. This growth is especially impressive given that residential investment continued its sharp decline and non-residential investment also fell in the quarter.
Consumption grew at 4.4 percent annual rate in the quarter, contributing 3.05 percentage points to GDP growth. Both durable and non-durable goods consumption had strong quarters, growing at 6.0 percent and 6.9 percent annual rates, respectively. The durable goods performance was especially striking because car sales actually declined modestly. The category of furniture and household equipment (which includes electronics) grew at an extraordinary 15.3 percent annual rate. The 6.9 percent growth rate for non-durable goods was the strongest since the third quarter of 2003. It is likely that unusually good December weather contributed to this growth, which was higher than most analysts had expected.
The improving trade balance added 1.64 percentage points to growth, the first positive contribution of the trade sector since the 3rd quarter of 2003. Exports grew at a healthy, but unexceptional 10.0 percent annual rate. The main reason for the improvement in the trade balance was a 3.2 percent drop in imports, the first decline since the 1st quarter of 2003.
Government spending was also a big net positive in the quarter, growing at a 3.7 percent annual rate, which added 0.7 percentage points to GDP growth. Most of the story was defense spending, which increased at an 11.9 percent annual rate.
On the negative side, residential construction plunged at a 19.2 percent annual rate. This is the third consecutive quarter of double-digit declines. Output in the sector is 12.6 percent below its year ago level. Non-residential construction also showed a modest drop, declining at a 0.4 percent annual rate. The equipment and software component declined at a 1.8 percent annual rate, while structures increased at a modest 2.8 percent rate. All categories of equipment investment fell in the quarter. The weak growth in structure investment followed two quarters of double-digit gains. Clearly, there was pent-up demand in this sector as a result of resources being diverted by the housing boom. That demand has now been exhausted, so that future growth will be much more modest.
Inventories grew at a modest pace after two quarters of relatively strong growth. The slower pace of inventory accumulation subtracted 0.71 percentage points from growth.
Output in the non-farm business sector increased at a 4.2 percent annual rate, which means that productivity growth will be close to 2.0 percent for the quarter. This follows two quarters of very weak growth. While this is a better performance than expected, it certainly does not dispel concerns that productivity is now on a slower growth path. Weaker productivity growth is not affecting inflation at this point, with the over GDP deflator rising at just a 1.5 percent annual rate. The core PCE rose at a 2.1 percent rate.
Output of motor vehicles reportedly declined at a 31.7 percent annual rate after rising at a 27.4 percent rate in the 3rd quarter. This repeats a pattern of a strong 3rd quarter followed by a very weak 4th quarter from the last three years, suggesting a problem with the seasonal adjustment in this sector.
This report indicates that the economy had considerable strength in the 4th quarter. However, it is questionable how persistent this strength will be. If the strong growth of consumption was in part weather driven, then consumption growth will be weaker than trend in the months ahead. The savings rate for the quarter was -1.0 percent, slightly above (less negative) the levels of the prior two quarters. Clearly, consumption is still being sustained by heavy borrowing against home equity. The decline in the trade deficit, driven by falling imports, is also not likely to be sustained. In addition, defense spending is not likely to jump again in future quarters. On the plus side, the rate of decline in residential investment is certain to slow. On net, the economy should experience modest growth, unless house prices start to decline more rapidly.