Here Comes the Hard Part
I’m sorry to be the bearer of bad news, but I think the hard part of our economic life is starting now. The economy is clearly slowing but inflation is still a problem and now the pain really begins.
GDP Slowing
The Q2 numbers for US GDP come out July 28. But they already revised data for Q1 and it was a little worse than originally estimated. The US economy contracted by 1.6% in Q1 and inventories started to build up.
The Bureau of Economic Analysis, the BEA, releases GDP estimates[1]. This was their third revision of the Q1 numbers. Remember, it takes a lot of time to gather all the relevant data for the entire US economy. And especially during turbulent times GDP numbers get revised for months and months as better data is finally collected.
The BEA explained that “Profits decreased 2.2 percent (revised) in the first quarter…” And “[p]rivate goods-producing industries decreased 6.9 percent, private services-producing industries decreased 0.8 percent, and government increased 2.0 percent. Overall, 9 of 22 industry groups contributed to the first-quarter decline in real GDP.”
That’s bad. We see the declining profits in the stock market’s performance this year as well.
The inventory piece of their announcement is worth noting: “The "third" estimate of GDP … primarily reflects a downward revision to personal consumption expenditures (PCE) that was partly offset by an upward revision to private inventory investment”.
That upward revision to private inventory investment means business produced and sold things that then sat on shelves (i.e., “in inventory”). It shows up as initial sales but will mean less demand for that product next quarter because the stores still need to sell the extra inventory from Q1.
Of course it’s a little more complicated since there are other reasons to also invest in inventories, but let’s say in this situation, half of that revision is a bad sign for Q2.
The BEA then explains that “[t]he decrease in real GDP reflected decreases in exports, federal government spending, private inventory investment, and state and local government spending, while imports, which are a subtraction in the calculation of GDP, increased”.
These are all factors driving aggregate demand in the economy. The drop in government spending has a mixed effect. Yes, it directly decreases demand but government’s excessive past spending was part of the cause of our inflation problem today. A drop in federal spending isn’t all bad.
And, keep in mind that the government doesn’t produce anything so 100% of it’s income to pay for that spending comes from taxes, borrowing or printing money. That is, in the end, it’s the American people paying the government to buy stuff from the American people. Without that, they could just buy and sell it directly.
The exports falling and imports rising are part of the continuation of two processes.
First, GDP is slowing in other countries. This means less demand for US goods and hence less US exports to those countries. Second, the US dollar is strong and continues to strengthen relative to most countries. A strong USD means it’s cheaper for Americans to buy foreign goods (imports) but more expensive for foreigners to buy American goods (exports).
This leads to more imports and less exports and both imply less demand for US-produced goods and hence less aggregate demand overall. This is especially true during tough times like now. When incomes are relatively fixed, then buying more foreign goods means you buy less domestic goods. That’s where we are today.
When an economy is growing, domestic consumers have rising incomes and can buy more foreign and domestic goods both. But that’s not our situation at the moment, sadly.
Wage Growth and Unemployment
Real incomes in the USA have been falling for about a year now. Wage growth is about 6% and inflation is about 8% so people on average are losing 2% a year in real wages. Each paycheck buys less and less at the store. And we all feel that. And again, it’s hardest on those in the lowest income categories, so this problem is always extremely harsh and harshest on those least able to bear it.
This is surely one of the reasons unemployment has continued to stay so low. To be blunt about it, inflation at 8% means companies are selling things at 8% more than last year. But wage growth at 6% means they are only paying their workers 6% more. So workers are relatively cheap for companies. Hence they are demanding more and more workers.
Normally that would also push up wages. And some of this is happening, hence the 6% rise. But labor is only part of the cost for a company.
The latest Bureau of Labor Statistics, BLS, report on producer prices[2] shows that the prices producers are paying for inputs rose around 10% or more in recent months.
Before we all go yelling at those greedy companies for charging 8% more but only paying people 6% more let’s realize that the 6% rise in wages is one cost and the 10% rise in everything else is the rest of the cost. So most businesses are actually struggling to earn a profit in this environment yet they are “strangely” demanding more and more workers (because workers are still the relatively cheaper input to production).
And, we see this in the BEA’s report, quoted above: “Profits decreased 2.2 percent (revised) in the first quarter...” And “Overall, 9 of 22 industry groups contributed to the first-quarter decline in real GDP.”
Everyone is feeling the squeeze.
Tighter Conditions and Negative Q2 GDP
This is all coming to a head now. Hiring seems to be slowing as companies struggle to keep positive profits. The US Dollar remains strong and will likely continue to strengthen as the US Fed raises interest rates further and the US continues to be the global safe haven for investors. That means more imports, less exports, and a drag on GDP.
All consumers and workers are feeling the pain as real wages remain negative and now as profits disappear which means less jobs will be available. Yet the prices in the stores remain high and will continue to rise due to inflation.
The Atlanta FED’s GDPNow currently forecasts that Q2 GDP is negative[3]. Currently it estimates -1.0%. But to return to a theme from an early column, the GDP is just a number. It doesn’t really matter. But it’s a sign of something that does matter: less opportunity to work, earn a living and buy affordable products.
And the pain is almost inversely related to income and wealth. The wealthy lose money for sure but the poor lose food and jobs.
It’s frustrating and infuriating because it didn’t have to be this way. There is no natural tendency for this sort of thing to occur. This is the economy – and the world economy…this is not just happening in the USA – adjusting after a very strange sequence of events.
The adjustment to a Covid shock would have been painful enough, but it didn’t need to include massive stimulus financed by massive money printing and the US Fed and other central bankers could easily have started to tighten the reigns last year. We are only having to slam on the economic breaks now because of the earlier excesses and a failure to act sooner.
Buckle In
That being said, the news will look worse and worse in the coming months. And with interest rates rising the political battles in all capitals around the world will be worse. Borrowing is now expensive. High interest rates mean financing (especially by rolling over short-term debt which the US government loves to do) is more expensive.
And government and central bank stimulus packages can’t save us from a recession and fight inflation at the same time since they are what caused the inflation in the first place. And if they try to spend their way out of this mess, they will have to spend more because each dollar or euro or British pound is worth less (about 8-10% less than last year). And if they try it anyway, inflation will skyrocket.
All this sets the stage for serious political fights while the rest of humanity sits at home worried about paying for groceries this week.
Buckle in.
[1] At a glance: https://www.bea.gov/news/glance ; and, the full report: https://www.bea.gov/news/2022/gross-domestic-product-third-estimate-gdp-industry-and-corporate-profits-revised-first )
[2] BLS report: https://www.bls.gov/news.release/ppi.nr0.htm
[3] Atlanta FED: https://www.atlantafed.org/cqer/research/gdpnow