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News & Analysis US

Many Moving Parts

June 3, 2014, Tuesday, 13:18 GMT | 08:18 EST | 17:48 IST | 20:18 SGT
Contributed by Raymond James


The U.S. economy contracted in the first quarter, but it appears very unlikely that we’ve entered a recession. Weather disruptions and the late Easter have made it difficult to gauge the underlying trends in the economic data, but a significant second quarter rebound appears to be baked in. Still, taking the first two quarters together, growth in the first half of the year is likely to be disappointing relative to earlier expectations. The main risk to the economic outlook is that we’ll end up with “more of the same” in the second half of the year – that is, the economy continues to recover, but not at a sufficient pace to take up the slack that was created during the downturn.

Econ 1: Gross Domestic Product (GDP) is a flow (dollars per time), while inventories are a stock (dollars). The change in inventories (dollars per time) contributes to the level of GDP. Hence, the change in the change in inventories contributes to GDP growth. In other words, if inventory growth increases, that will add to GDP growth. If inventory growth slows, that subtracts from GDP growth. Over time, inventories should rise more or less in line with the pace of final sales.

The pace of inventory growth picked up sharply in 3Q13. With such a pickup, we normally see a slower pace in the following quarter – but that didn’t happen in 4Q13. Instead, the pave of inventory growth remained unsustainably high. The 2nd estimate of 1Q14 GDP now shows that this correction has finally arrived. Leaner inventories should bode well for future increases in production. The trade deficit widened in the first quarter, which further subtracted from growth. Taken together, the drop in net exports and the slowdown in inventory growth subtracted 2.6 percentage points from overall GDP growth in 1Q14. Domestic Final Sales, which excludes net exports and the change in inventories, rose at a 1.6% annual rate, the same pace as in 4Q13 – certainly not strong, but not horrible either.

Consumer spending rose at a 3.1% annual rate in the 2nd estimate for 1Q14 (vs. +3.0% in the advance estimate). Weather was a restraining factor, but spending was boosted in two other areas. The Affordable Care Act appears to have contributed to an increase in healthcare, which rose at a 9.1% annual rate and contributed a full percentage point to GDP growth in 1Q14. That followed a 5.6% annual rate in 4Q13 and a 2.4% average over the 10 previous quarters. In addition, colder-than-normal temperatures led to a jump in home heating expenses in 1Q14. Spending on electricity and natural gas fell 7.8% (seasonally adjusted) from March to April, which is the main reason that overall spending slipped 0.1% (-0.3% adjusting for inflation). Assuming moderate increases in spending in May and June, we should see an inflation-adjusted pace of spending of about 2.5% in 2Q14 (but we’ll need to see that confirmed in the data).

Long-term interest rates normally trend higher during an economic recovery, but they should not rise so much that they threaten the recovery. Adverse weather was a restraint on housing activity in the first quarter, but softness appears to be due to more than simply bad weather. Higher mortgage rates (relative to a year ago) and rising home values have priced many potential homebuyers out of the markets. The recent drop in mortgage rates will help to improve affordability to some extent, but the housing data bear watching closely in the months ahead. A full housing recovery is not a necessary condition for continued expansion in the overall economy, but all else equal, we’d like to see some strength in housing in the near term.

Long-term interest rates are lower than where they were at the beginning of the year and well below where they were projected to be at this point. There are a number of reasons for the recent drop. The Treasury is borrowing less, but that should have been already factored in. Inflation has remained low. Fed policy has been a bit confusing for the markets. The Fed is still adding policy accommodation as it tapers the monthly pace of asset purchases. Given the drop of Treasuries being issued, the Fed’s pullback in asset purchases shouldn’t have much of an impact. The Fed has clearly signaled that, barring a significant change in the economic outlook, the tapering will continue “at a measured pace” (although “not on a preset course”). The key question is when the Fed will begin to tighten policy. Until recently, the Fed was expected to begin the process of unwinding its policy accommodation by first ending its practice of reinvesting maturing securities in its portfolio. However, there’s a current debate at the Fed about whether interest rates should be raised first and which rate to use (the federal funds target or the interest rate that the Fed pays on excess reserves held at the Fed). This will be settled over time, but the bottom line is that we’re unlikely to see any tightening of monetary policy until around the middle of next year (although that depends on the outlooks for growth and inflation).

More recently, U.S. bond yields have been pushed down on global concerns. There may be some flight to safety (probably not a lot) due to geopolitical tensions. European investors expect the ECB to ease this week, which has put downward pressure on global bond yields. Softer global growth is a risk for the U.S. economy and may limit the growth in exports.

While the estimate of 1Q14 GDP was revised lower, forecasts of 2Q14 GDP growth are expected to be revised higher. However, even if we see 4% to 5% GDP growth in 2Q14, the first half average would be 2% or less. Growth is still anticipated to pick up to 3.0% to 3.5% in the second half of 2014. The major risk now is that it won’t. The longer GDP remains below its potential, the greater the likelihood that potential GDP will slow.

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