October 26, 2023
Strong growth across sectors propelled the economy in the third quarter, as the inflation rate slowed to a pace only slightly above the Fed’s target. The 4.9 percent growth rate was the fastest since the 7.0 percent reported for the fourth quarter of 2021. At the same time, the annual inflation rate, as measured by the Federal Reserve Board’s preferred measure, declined to 2.4 percent, just above the Fed’s 2.0 percent target.
This report is very encouraging in several different ways. While the overall growth rate is almost certainly well above the economy’s sustainable growth rate, much of it was driven by a more rapid pace of inventory accumulation. Final demand grew at a 3.5 percent rate, which is still fast, but not obviously out of line with the economy’s potential.
The growth for the quarter also implies another quarter of rapid productivity growth. Productivity grew at a 3.5 percent pace in the second quarter. It is likely to come in above 2.5 percent in the third quarter. The productivity data are always erratic, and even more than usual since the pandemic, but this is still encouraging.
Finally, the report provides further evidence of slowing inflation. The Fed may not yet be prepared to declare victory, but with inflation this close to its target, it would be hard to justify any further rate hikes, and reasonable to begin to think about cuts.
Consumption Remains Solid, Healthcare Costs Pick Up
Consumption grew at a solid 4.0 percent annual rate. Durable goods consumption grew most rapidly, rising at a 7.6 percent pace. Car sales were only a small part of this rise. The biggest single factor within durable goods was an extraordinary 29.7 percent increase in the purchase of computers and related equipment. Some of this likely is for home offices.
Non-durable consumption rose at a more modest 3.3 percent rate, while service consumption increased at a 3.6 percent rate. Because inflation in services was far more rapid than inflation in goods, 4.0 percent in services compared to 0.8 percent in goods, the service share in nominal consumption expenditures rose, but it is still far below its pre-pandemic pace.
In this respect, it is notable that nominal spending on healthcare services has been rising rapidly in the last year. It was up 7.9 percent from its year-ago level, although it rose at just a 5.4 percent rate in the third quarter. Healthcare spending had slowed sharply during the pandemic, but has been bouncing back in the last year. The third quarter level is still slightly below the pre-pandemic pace of 5.0 percent.
Investment Growth Slows to a 1.0 Percent Pace
All three major categories of investment were weak in the third quarter with structure investment actually declining at a 1.8 percent rate. This was driven largely by a 27.5 percent rate of decline in mining structures, reversing most of the surge in the second half of 2022. (Oil production has been at record levels.) Construction of factories grew again at a double-digit pace, rising at an 18.8 percent rate. Factory construction is now 65.7 percent above its year-ago level.
Equipment investment rose at a 2.2 percent rate, while investment in intellectual products increased 1.6 percent. It is worth noting that, insofar as consumption spending on computers and related equipment is actually being used for home offices, it would lead to an understatement of actual investment in equipment. The growth in spending on intellectual products has been depressed in the last two quarters by the writers’ union and Screen Actors’ Guild strikes. These have curtailed the production of new movies and television shows.
Residential Investment Turns Positive
Residential construction rose at a 3.9 percent rate, the first time it has been positive since the first quarter of 2021. Much of the story here is the end of the refinancing boom. Many of the costs associated with refinancing appear in this category. Now that refinancing has fallen to virtually zero, it cannot drop further. In spite of a drop in housing starts, the backlog created by pandemic supply chain problems should keep construction healthy into 2024.
Inventories Add 1.32 Percentage Points to Growth in Quarter
The pace of inventory accumulation slowed to near zero in the second quarter, which meant that a return to a normal pace would lead to a large addition to GDP growth. Inventories grew at somewhat faster than normal $80.6 billion annual rate in the third quarter. There will likely be some falloff, meaning a drag on growth in the fourth quarter.
Defense Spending Spurs Strong Growth in Government Expenditures
Defense spending grew at an 8.0 percent annual rate, driving a 4.6 percent pace of growth of government spending overall. The sector added 0.79 percentage points to growth in the quarter. The timing of defense spending is always erratic, but with the wars in Ukraine and the Middle East, heightened spending in this category may continue. State and local government spending grew at a 3.7 percent pace, roughly the same as its pace over the last five quarters.
Trade Deficit Rises Modestly
After falling sharply in 2022, as the economy switched back to consuming services rather than goods, the deficit has changed little in the last three quarters. The rise in deficit in the third quarter, measured in real dollars, reversed a small decline in the second quarter. (It fell modestly in nominal terms.)
Inflation Continues to Slow
Inflation, by most measures, continued to slow in the third quarter. The core personal consumption expenditure deflator, which the Fed targets, fell to a 2.4 percent annual rate of growth in the third quarter. This is down from a peak of 6.0 percent in the first quarter of 2022 (also the second quarter of 2021). With shelter inflation continuing to slow, inflation is likely to decline further in the next two quarters.
Very Solid Report by Almost Every Measure
Virtually all the news in the third quarter GDP report was positive. The 4.9 percent growth figure is clearly faster than the economy can sustain, but if we pull out the unusual jump in inventories, the 3.5 percent growth in final demand is much closer to a sustainable pace. The productivity number will be strong for a second consecutive quarter, raising the hope that AI and other technologies may have the economy on a faster growth path. And, the story on inflation suggests that the Fed’s battle is almost won.
The one concerning item is the slowing of investment growth. There are measurement issues, such as the possible displacement of business investment into consumption expenditures for home offices. Also, there should be a rebound in investment in intellectual products when the actors’ strike ends, but high interest rates could be having an impact here.