U.S. GDP Drops Slightly in Third Quarter, But Worse to Come

The key takeaway from the report is that the signals for private-sector spending were almost all negative. Consumer spending fell by 3.1%, the first decline since the fourth quarter of 1991 and the biggest drop since credit controls decimated spending in the second quarter of 1980. Bear in mind that this decline preceded the massive drop in household wealth produced by October's stock market collapse. Business equipment spending fell again, residential construction continued to plunge, and export growth slowed. The only area of private strength was in business structures, which was driven by oil and gas drilling. The construction component of business structures has not yet plunged, but is running on empty; financing is drying up, as is demand for new retail or office developments.

It may seem surprising that GDP growth could still be close to zero, even though private-sector spending fell so sharply (consumer spending was down 3.1%, fixed investment was down 5.6%). There were areas of offsetting strength, but unfortunately not ones that can be relied upon in subsequent quarters.

• Foreign trade added 1.1 percentage points to growth, as exports rose and imports fell. But export growth was less robust than in the second quarter, and with the recession now becoming global, the export outlook is rapidly deteriorating.
• Government consumption added 1.2 percentage points to growth, largely due to an 18.1% annualized increase in federal defense spending. Defense spending is on an uptrend, but that size of increase is just temporary. And state and local governments will have to cut their spending.
• Inventories fell at a slower pace than in the second quarter, which means that they added to the rate of GDP growth (their contribution was 0.6 percentage point). The picture is muddied by the hurricanes, which led to inventory rundowns in the oil, gas, and chemicals sectors. Those stocks will need to be rebuilt. But in the rest of the economy, the steepness of the drop in final demand likely means that unwanted inventories are building up, which will have to be run down in subsequent quarters. On net, inventories will be a drag on future growth.

The inflation part of the report showed the last gasp of the commodity-driven surge in headline inflation. The GDP price index rose 4.2%, and the personal consumption price index rose 5.4%. In the fourth quarter, GDP price inflation will slow and the consumption price index will actually decline as gasoline prices plunge.

The economy ended the third quarter much weaker than it began, even before the most extreme turmoil in global financial markets erupted in October. The October crisis has hit an economy that was already on the way down, and it will intensify the recession. In the fourth quarter, private spending will continue to decline, and we can't expect another huge surge in defense spending to prop up real GDP growth. A fourth-quarter decline in real GDP on the order of 3.0% is likely. We are now entering the harshest part of the recession.