U.S. Economic Growth and Implications
The latest BEA report on U.S. economic numbers (Thurs., July 15th) shows economic growth was strong at 2.8% for the second quarter. That was much stronger than expected.
First quarter growth was only 1.4% and most analysts expected 2.1% for Q2. So this was a strong result indeed, and we should be glad about it. As a general rule, more GDP growth is better than less.
The strong growth number, however, has been leading to a little policy consternation. The question many people are asking now is whether we are seeing a “soft landing” from the Fed’s anti-inflation policies or not. A soft landing would mean, slowly falling inflation while experiencing steady economic growth and relatively low unemployment.
If we are experiencing a soft landing, then the Fed should start cutting interest rates soon. If not, then there are two cases. In the first case, we are “crash landing”, that is, entering a recession. In that case, the Fed will cut fast as the economy sinks and unemployment rises. In the second case, we are are “lifting off” again and the Fed have to raise interest rates.
This column just reviews how I read and interpret the report.
The Fed vs Congress: The Main Concern
In recent years, the economy started growing again but inflation rose rapidly, peaking around 9% in the United States. The Fed raised interest rates in an effort to fight inflation. The main effect of raising interest rates is to contract demand for borrowing money (i.e., loans and credit card usage), which affects demand for certain goods, namely those requiring financing.
The basic idea is that as people borrow less, they buy fewer goods and they feel their overall budgets tighten. While this hits some interest-sensitive goods hardest, if the Fed raises rates high enough and for long enough, it should slow demand for everything a bit and hence ease pressure on prices, lowering inflation.
The problem is that, while the Fed has been pursuing the above process, the U.S. Congress has been deficit spending like crazy, which increases demand for goods and services. That means, one branch of government - the Fed - has been putting the breaks on the economic engine while another branch - Congress - has been pushing on the gas.
The government’s spending and financial problems are a whole story in themselves. Deficits today are high and expected to remain high.
The Congressional Budget Office explains that “total deficits [are expected to be] equal or exceed 5.5 percent of GDP in every year from 2024 to 2034. Since at least 1930, deficits have not remained that large for more than five years in a row. Over the past 50 years, the total annual deficit has averaged 3.7 percent of GDP.” (CBO link).
That’s a problem, and is inflationary in its own right. Today the concern is that Congressional spending is overstimulating the demand that the Fed is simultaneously trying to slow.
The Type of Growth
What else can we learn from the BEA report? It shows us the areas of the economy and how much they grew or shrank by. As a general rule, we’d like to see a strong, thriving private sector. So, we can look for that versus government/stimulus driven growth.
Private consumer spending grew by 1.57%, mostly in services, and most of that service spending was on health care. That is being largely interpreted as government-driven, or at least mostly government-driven growth.
We also see that private investment grew by about the same, 1.46%, which is a good sign and actually surprising given that investment spending usually falls when interest rates are high. That’s definitely encouraging.
Those together would give 3.03% growth but the trade deficit was - .72% bringing us down to 2.31%. The difference is made up by pure government spending growing at .53% bringing the total to 2.84%.
Those numbers can all be found on page 8 of the BEA’s report for anyone interested (BEA link).
It’s a bit concerning to see so much coming from health care spending. As mentioned above, the negative interpretation is that it’s government-driven. We indeed have a very poorly run pseudo-government/pseudo-private health care system that is a total mess in my opinion. So it’s hard to tell what more growth in this sector means.
A good interpretation is that we have an aging population that is simply demanding more services. That may be a challenge for social security and similar funding going forward, but it would be a sign of normal economic response to this.
Overall, I came away neutral after looking through the details of the report. I didn’t see anything saying this was specifically government over-stimulus. Nor, however, did I see the opposite.
Now, to think about implications of all this, I want to bring in what we know about unemployment and inflation as well.
Unemployment
The latest unemployment rate was released on July 5th. It showed that unemployment last month rose, hitting 4.1%.
That alone isn’t too bad. We believe the U.S. economy remains comfortable around 4% unemployment plus or minus a little bit (see my past column, “y r U stars not aligning?” for criticisms of how we get that number). The problem is the trend.
In 2023 we went from 3.4% unemployment at the start of the year to 3.7% by the end. This year, we’ve gone from 3.7% at the start of the year to 4.1% last month, up from 4% in May. Clearly a slow rise in unemployment over the last year and a half.
That continued rise in unemployment makes the strong GDP number a bit surprising. It’s a relief, but it’s surprising. As a result, it is leaving analysts a little uncomfortable with it, or rather, unconvinced by it.
We can add to that unease by noticing that 74% of the total jobs added in June were in the Government (34%) and Health Care (40%) sectors1. Again, a sign that the growth is being driven by government stimulus.
Both retail and professional & business service lost jobs. Not good.
The only bright sign I saw in that report is that construction jobs were up, accounting for 13% of the job gains in June. Let’s hope they were mostly private projects, but I fear many come from the government’s infrastructure spending from 2021 that’s still washing through the economy.
Inflation Numbers
The latest inflation report, released July 11th, showed continued but slow improvement. The consumer price index, CPI, declined by 0.1% from May, hitting 3.0% overall and 3.3% if you exclude food and energy prices. That’s still a long way from the Fed’s 2% target.
As a quick sidebar, there are numerous measures for the price level in an economy. The Fed always claimed to prefer the PCE which is indeed around 2.5% now. But when the CPI excluding food and energy was better, they referenced it, when the CPI including food and energy improved, they referenced it and so on.
I mention all that because you see a lot of different inflation numbers today and might be confused. I always focus on the overall CPI.
Rate Cut Conclusions
Fed policy thinking can be well captured by focusing on two metrics. The first is inflation versus target inflation. That’s called the “inflation gap” - actual inflation (3%) minus target (2%) - and, currently, it’s +1. Based on that, the Fed should not cut interest rates. Technically, they should raise them, but they sort of watch inflation over a longer horizon, so I expect this alone will not push them to raise rates. If, however, inflation stays here, they should raise rates.
The second metric is the “output gap” which is actual GDP growth minus ideal (or “potential”) GDP growth. We can’t measure ideal GDP growth perfectly so they often use some trend GDP growth estimate. Currently the CBO’s estimate is that potential growth is around 1.7%-2% (see graph in FRED here).
The latest 2.8% growth number is above these potential estimates for sure. Of course they usually consider growth rates over a longer horizon too. If you average the Q1 and Q2 growth rates, 1.4% and 2.8% respectively, you get 2.1% which is still slightly above the potential estimates.
Since potential GDP is hard to measure, most people look at the “unemployment gap” as well which is defined as actual unemployment (4.1%) minus ideal or potential unemployment currently estimated at 4.2% (see graph in FRED here). Again, potential is hard to measure and may generally be miscalculated (see my past column, “y r U stars not aligning?” which dealt with this issue in detail).
Economists often look at both the output gap and the unemployment gap since neither is perfect.
Summarizing thus far, based on this information,
Inflation is still above target. Therefore the Fed should hold or raise rates if this doesn’t improve.
Output growth is above target. Therefore the Fed should hold or raise rates if this doesn’t improve.
Unemployment is slightly below target. At 4.1% actual vs. 4.2% “ideal”. Therefore the Fed should hold or lower interest rates if this doesn’t improve.
Two marks for hold or raise rates. One mark for hold or lower.
Political Conclusions
In case you didn’t know, we have a presidential election in the U.S. this year. If you are on the incumbent’s side, the interpretation of the data is that we have a strong economy with relatively low unemployment and falling inflation. You are hoping that it continues and the Fed cuts in, say September, so voters feel a small improvement in their economic lives and give credit to the incumbent.
If you are on the other side, the interpretation is that the economy is over stimulated by fiscal spending, exhibits rising unemployment and is still struggling with inflation and high interest rates. You are hoping that GDP growth slows, inflation remains and the Fed doesn’t cut rates in September. Voters would continue to feel the pain and blame the incumbent.
I don’t view data in a political light, but I think it’s helpful to always recognize how it can, and likely will be, interpreted by each side.
Personally, I do think GDP growth is coming from some overstimulation and I worry about that, especially long-term since debt and deficits are out of control. I also always prefer to see growth coming from the private sector as purely as possible because this gives me the most confidence that it’s real and beneficial growth.
As I mentioned in “Soft Landings in Economic Helicopters” in October last year, I also worry about overshooting the inflation target because monetary tools are blunt instruments. Economies slip into recessions on a dime, always surprising us, and there’s no reason to think this time is different.
But, we’ve all been predicting a recession for almost 2 years now.
So… my best guess is that
(a) the Fed won’t change anything at its meetings this week,
(b) GDP growth will slow for Q3 since the Q2 number seems high to me when unemployment is also rising,
(c) I don’t know about Q4, that’s too far off,
(d) inflation will continue to fall towards 2% and, finally,
(e) that means we will see a rate cut at their September 17-18 meeting, perhaps.
The interesting predicament the Fed faces today is political. The next meetings are this week, July 30-31, then September 17-18, and finally, November 6-7. The US elections are Tuesday, November 5th.
It seems to me that they are damned if they do and damned if they don’t change rates in September. Suppose the data remains mixed. Then, if they cut rates in September, the Republicans will cry foul, claiming the Fed is trying to help the Democrats (incumbents in the U.S.). If they don’t cut, the Democrats will cry foul, claiming the opposite.
The only chance for the Fed is if there is a clear movement in the inflation or GDP numbers that clearly warrant, say, a rate cut. In that case, everyone will be able to see they had to cut rates.
We’ll see.
That total health care number breaks down to 24% in Health Care only and 17% in Social Assistance which is a subsector in Health Care more broadly, hence the reason I added them to get 40%.