U.S. GDP Growth Improves in the Second Quarter

The second-quarter outcome is most easily understood by splitting GDP into three components: domestic final sales, inventories, and foreign trade.

Growth in domestic final sales—purchases of goods and services by U.S. residents, but excluding inventory changes—accelerated in the second quarter to 1.3% from just 0.1% in the first quarter. Consumer spending growth improved to 1.5% from 0.9%, helped by the boost from the stimulus payments that began in late April. Without those payments, consumer spending growth would probably have decelerated again. Residential construction spending continued to decline, but did so less steeply than in the first quarter. Government spending growth accelerated, as federal spending growth was very strong—both defense and nondefense—and state and local government spending edged higher after declining in the first quarter. And business spending on structures grew faster than in the first quarter. Business equipment spending declined.

At the same time that domestic final sales improved, companies shed inventories at a rapid pace. The drop in overall inventories was sufficient to subtract 1.9 percentage points from GDP growth. The drop was especially steep in manufacturing. Retail inventories of motor vehicles also declined, as manufacturers cut production (partly involuntarily, due to the American Axle strike).

The negative effect of inventory decumulation on real GDP was more than offset by a huge improvement in foreign trade. Real exports rose 9.2%, while real imports fell 6.6%. That combination meant that foreign trade added 2.4 percentage points to real GDP growth—the largest positive quarterly contribution from trade in nearly 28 years.

The overall picture shows the economy keeping its head above water in the second quarter, helped by the stimulus support to the consumer, the beginnings of a flattening out in residential construction, and surging exports. It did so while accomplishing a sharp reduction in inventories, concentrated in the manufacturing sector.

The inventory reduction is a good sign for future growth, because it reduces the likelihood that an overhang of unsold goods would require future sharp production cuts. But we do not believe that it implies that growth is therefore bound to accelerate in the third quarter. There is a linkage between the negative inventory contribution to growth and the positive trade contribution. The reduction in inventories is likely linked to the improvement in exports (shipping out goods previously produced) and to the decline in imports (bringing in fewer goods from abroad). Just as it is unlikely that inventories will subtract 1.9 percentage points from growth in the third quarter, as they did in the second, it is unlikely that net exports will add 2.4 percentage points to growth in the third, as they did in the second.

Today's report includes revisions to historical GDP data stretching back to 2005. It will take some time to digest all of the revisions and their implications, but the key features are:

• Real GDP growth was revised down in all three years subject to the revision: 2005 (down 0.2%), 2006 (down 0.1%), and 2007 (down 0.2%). Growth in 2007 now stands at 2.0% rather than 2.2%.
• The fourth quarter of 2007 now shows the first negative quarter since the 2001 recession. Growth in that quarter has been revised to -0.2% from the previous estimate of +0.6%. This keeps alive the possibility that a technical recession began in the fourth quarter—but the drop is very small, and the debate will stay open.
• Domestic spending (i.e., GDP excluding net exports) has been in recession since the fourth quarter, with a 1.0% fall in the fourth quarter, just a 0.1% improvement in the first quarter, and a 0.5% fall in the second quarter. The support from net exports explains why GDP growth has seen only one negative quarter despite these declines in domestic spending.
• In recent quarters, consumer spending growth has been revised down, notably for services. Since initial information on services spending is sketchy, and much of it is projected using trends, it is perhaps not surprising that during a period of economic weakness the service spending estimates are subject to downward revision.
• Producers' durable equipment spending growth has also been revised down for each quarter starting with the third quarter of 2007, and the first two quarters of 2008 now both show outright declines in spending. This revision reinforces the importance of foreign trade for equipment manufacturers. With domestic equipment demand sliding, manufacturers are dependent for growth either on exports or on shifting domestic spending away from imports and toward domestically produced goods.
• On the income side of the accounts, the level of corporate profits has been revised up throughout the past three years—but the pattern of profits growth has become more cyclical. Although their level is higher, pre-tax profits from current production now show year-on-year declines in every quarter from the first quarter of 2007 to the first quarter of 2008. Previously, these quarters all showed profit gains. Profits figures for the second quarter of 2008 have not yet been published.
• Inflation in the core personal consumption expenditures price index has been remarkably stable at 2.2% (year-over-year) since the fourth quarter of last year. The quarter-on-quarter annualized rates of increase have actually eased back slightly over that period, though also remaining above 2%. That is slightly higher than the Fed would like, but not a trigger for action on interest rates.

We continue to expect a W-shaped pattern to this business cycle, driven by the effects of the economic stimulus package. The stimulus helped to bring growth up in the second quarter, and we expect a similar rate of growth in the third (in the 1.5–2.0% region). But we expect the fourth quarter of 2008 and the first quarter of 2009 to show a payback, with the fourth quarter and possibly also the first quarter being negative. This growth profile should keep the Fed on hold for some time.