April 26, 2023
While there are serious grounds for concerns about further slowing and a possible recession in the second half of 2023, we should again see solid growth in the first quarter. The economy grew at a 2.6 percent annual rate in the fourth quarter of 2022. This was driven in large part by a big jump in inventories, which added 1.47 percentage points to the quarter’s growth.
Inventories will likely not be a major factor in first quarter growth, but we should see a comparable, if slightly slower, growth rate in the first quarter. Stronger consumption growth, coupled with a smaller drop in both residential and non-residential investment, are likely to make up for the reduced growth contribution of inventories.
Residential construction declined at a 25.1 percent annual rate in the fourth quarter, subtracting 1.2 percentage points from growth in the quarter. This followed a drop of 27.1 percent in the third quarter. The positive side to this decline is that we are not likely to see much further drop in the first quarter.
The biggest factor in the decline in residential construction was the end of the mortgage refinancing boom. Since the commissions earned on refinancing count in residential construction, when refinancing collapsed due to the jump in interest rates, it led to a large drop in reported construction. The decline in brokerage fees accounted for more than a third of the drop in residential construction since the fourth quarter of 2021.
Housing starts have fallen sharply since the Fed began raising rates, but because of the large backlog in unfinished homes, the number of housing units under construction is actually higher than when the Fed began raising rates. For this reason, we are not likely to again see a double digit decline in residential construction, although it will be a modest drag on first quarter growth.
There was a very mixed picture for non-residential investment in the fourth quarter. Equipment investment declined at a 3.5 percent annual rate, while investment in intellectual products grew at a healthy 6.2 percent rate, and investment in structures increased at a 15.8 percent rate.
The jump in structure investment was extraordinary. Essentially, the categories that were hardest hit in the pandemic are bouncing up off the bottom. Office construction grew at a 22.5 percent annual rate, although the fourth quarter level was still 27.9 percent below its level from the fourth quarter of 2019. Lodging construction grew at a 44.3 percent rate, but the level was still 53.1 its level from three years earlier.
Manufacturing grew at a solid 33.7 percent rate. It is already above its pre-pandemic level. This growth is likely being driven by the investment boom in clean energy and electric cars.
We are likely to again see a modest fall in equipment investment and modest growth in investment in intellectual products. The weakness in equipment investment is a response to recession concerns. Weakness in investment in intellectual products follows a sharp increase in the pandemic, which put the fourth quarter figure 24.4 percent above the pre-pandemic level. The tech sector layoffs, coupled with some cutbacks in the entertainment industry, should mean the first quarter will be close to flat.
Non-residential investment as a whole is likely to be close to flat in the quarter. Modest growth in structure investment will be offset by declines in equipment investment.
Consumption Growth Accelerates in the First Quarter
Consumption grew at just a 0.7 percent annual rate in the fourth quarter. A small decline in durable goods consumption offset already weak growth in consumption of services. Goods consumption likely increased at close to a 5.0 percent rate in the quarter, while service consumption will likely show an increase of around 2.0 percent. This should put the overall rate near 2.5 percent.
The biggest question going forward is whether consumption can sustain anything close to its recent growth rate. Given its importance in GDP, if consumption is growing anywhere near 2.0 percent, we can rule out a recession.
Job growth is clearly slowing, but there is still no obvious basis for expecting it to turn negative. Wage growth has moderated, but so has inflation. The real average hourly wage actually increased by 0.2 percent in March, in spite of slower nominal wage growth.
With rental inflation likely to slow sharply in coming months, based on data from private indexes of marketed rental units, and food commodity prices drifting downward, it seems likely we can sustain modest real wage growth. If job growth continues at just a 1.0 percent annual rate (130,000 jobs a month), this should make it possible to sustain 2.0 percent consumption growth, without any change in the saving rate.
Of course, we may see some upward drift in the saving rate insofar as people are now spending down pandemic savings that will soon be depleted. This story has likely been overstated, as much of the explanation for the fall in the saving rate is higher taxes that people are paying, presumably due to selling stock at a gain. But the end of the pandemic mortgage refinancing boom removes one factor that helped to spur consumption, so this will create at least a modest headwind.
Inventories and Trade
In the fourth quarter, inventories added 1.47 percentage points to growth and trade added 0.42 percentage points. We had very large inventory swings since the pandemic, with slowing or accelerating accumulation being a major factor in GDP growth in many quarters. The pace of accumulation was very rapid in the fourth quarter, which means that we will likely see somewhat of a drag from inventories in the first quarter. Trade is likely to again be a positive factor in GDP, as export growth is slightly outpacing import growth.
Conclusion – Economy Still Looks Solid
The economy is likely to show strong growth in the first quarter, with no obvious signs of a recession on the horizon, unless the fallout from the Silicon Valley Bank’s collapse is deeper and longer lasting than is generally expected. Residential construction will fade further as the backlog of unfinished houses is exhausted, but this will be a gradual process. Non-residential construction has already turned the corner.
We will get inflation data with this report, showing whether the PCE deflator has slowed to the same extent as the CPI. If we get a good story with these data, it will strengthen the case for a Fed pause on interest rates at its May meeting.