Last week the U.S. Bureau of Economic Analysis released an advance estimate of the gross domestic product (GDP) numbers for the U.S. economy in the second quarter. Comments from the media typically ran along the lines of this CNBC article:
The U.S. economy showed few signs of recession in the second quarter, as gross domestic product grew at a faster-than-expected pace during the period … GDP, the sum of all goods and services activity, increased at a 2.4% annualized rate for the April-through-June period, better than the 2% consensus estimate from Dow Jones.
CNBC is correct in that the economy is indeed steering clear of a recession, something I predicted already in April. Back then I noted that a “recession is less likely” than it had been at the end of 2022. I based this conclusion on the fact that there were signs of a turnaround from last year’s drop in certain types of business investments, with other types of investments rising. This, I explained, suggested that “business managers expect a good 2023.”
In June, I reaffirmed my optimism about the near-term future for the U.S. economy, contrasting it against statements from the Federal Reserve which at the time foresaw a virtual standstill for the U.S. economy through 2025.
With all that said, CNBC makes the same mistake as practically every other analyst out there. They use the so-called annualized figure for GDP. I am not going to go into the technicalities of why this is the wrong number—click here for a detailed explanation—but the good news is that the actual growth rate in GDP for the second quarter is not far from the number that CNBC mentions.
Adjusted for inflation, the U.S. GDP expanded by 2.7% in the second quarter. This number compares real GDP in Q2 this year with real GDP in Q2 last year. It is not adjusted for seasons and not annualized. It is as close as we can get to the raw data on what is actually happening out there in the economy; the only adjustment is for inflation. This is up from just below 2% in the first quarter and 0.9% in the last quarter of 2022. It is also higher than the paltry 2.25% average growth rate in the 2010s.
I have no idea why everybody else insists on using the seasonally adjusted, annualized numbers, but I do know one thing: when you use data that has been ‘massaged’ in different ways, you get so far from reality that it becomes virtually impossible to make accurate predictions of where the economy is heading.
Perhaps this is why the Federal Reserve in their Monetary Policy Report, published in June, predicted that the U.S. economy will virtually stand still through 2025. As of today, it looks like their prediction is wrong, which we should all be thankful for. As I explained in my analysis of their report, if they were to be correct it would have brutal consequences for the finances of the federal government.
Thankfully, the latest GDP numbers from the Bureau of Economic Analysis suggest that the Federal Reserve’s outlook was overly pessimistic. That does not mean that Congress can continue borrowing money as they are currently doing—all it means is that they have a little bit more time to avoid a fiscal calamity.
Normally, a 2.7% GDP growth figure would be a disappointment for the U.S. economy. Unfortunately, we have not been used to very strong growth recently. The Trump economy topped the current GDP numbers in 2018, when GDP grew by 3.7% in Q1, 3.2% in Q2, and 2.9% in Q3. At the same time, under President Obama, we did not have a single calendar year with 3+% growth.
Since growth numbers in 2020 and 2021 were distorted by the artificial pandemic-related economic shutdown and its aftermath, we really only have 2022 and early 2023 to compare to the economy that Trump presided over. So far, that economy has been moderately successful, with high employment and reasonably good consumer-spending numbers, but it has not yet shown the resiliency that would vouch for a strong, sustained growth period. The GDP numbers for the second quarter are welcome news in that regard, as they suggest that there still is some resiliency in the American economic machine.
Let me point out that not all is good in these numbers—I will point to a couple of problems in a moment—but there is enough good information in these numbers to be optimistic about the near-term future. Barring any catastrophic event such as an escalation of the war in Ukraine, Americans can look forward to a good fall and a reasonably good winter, at least from an economic viewpoint.
Consumer spending, which accounts for almost 71% of the economy, grew by 2.68%, in other words just a hair behind GDP as a whole. It was particularly good to see that consumer spending on durable goods—everything from kitchen appliances to passenger vehicles—increased by 4.3%. This category expanded by 4.4% in the first quarter; since these purchases are often bought with credit, this is a signal of optimism among U.S. households.
Spending on services, which accounts for about twothirds of consumer outlays, increased by 2.76%. This is down from 3+% since the full reopening of the economy in 2021, but it is still a solid number. Services include a wide variety of products, such as home deliveries, haircuts, legal assistance, rideshare services, airplane travel, children’s daycare, etc.
The trend in services spending, where the growth rate slowly drifts down toward an average number consistent with the growth in household income, indicates that consumers are settling in on a stable consumption pattern. American households have established a portfolio of services that they are willing to consume on a regular basis. Such spending patterns are good for the businesses in the services industry, which can offer stability in pay and work hours to their employees.
Speaking of businesses: investmentin so-called non-residential structures was up by a significant 7.7% year on year. This is a major turnaround from Q2 last year when businesses reduced their spending on structures by an inflation-adjusted 8.6%. We have now had two quarters in a row with growing structural business investments: in Q1 this category expanded by 2.67%.
These numbers are the first positive numbers for business structures since the first quarter of 2020. After the pandemic, American businesses spent a lot of time reducing investments in office buildings, factories, warehouses, vehicle garages, and other structures. The fact that we have a turnaround here tells us that my statement back in April about business managers having a positive outlook on 2023, was indeed correct.
Facilities of all kinds are the longest-lasting component of the capital structure that businesses use to produce whatever goods or services they provide. When businesses expand investments in these structures, they do so based on a multi-year outlook on the future.
To reinforce this good news, businesses also increased investments in equipment. After a standstill in Q1, this category expanded by 2.4% in Q2.
The expansion of investments is definitely motivated by increased consumer spending. On top of that, U.S. exports increased by 2.9% in the second quarter of this year. This is a drop from a 7% increase in the first quarter, but it is still an expansion. Goods account for about 72% of American exports, although that is slowly changing: services exports have outgrown goods exports for two years straight.
With imports declining for two quarters straight, the U.S. trade balance has been improving thus far in 2023. This contributes positively to GDP.
The one category of spending growth that we might want to be wary of is government outlays. All in all, U.S. governments—state, federal, and local—spent 2.8% more in Q2 this year than in Q2 last year. On the federal side, non-defense spending actually declined: it was a small drop, only -0.27%, but it was the sixth quarter in a row with declining non-defense federal outlays. Defense spending, on the other hand, expanded by 3.1%, marking the second quarter in a row that the Pentagon got an inflation-adjusted boost to its budget.
Of more concern is the growth in state and local government spending by a bit over 3.5%. This is the highest growth rate in their spending in four years. The BEA does not give any details of spending categories, but it is a reasonable guess that infrastructure spending accounts for the lion’s share of this expansion. It has been almost two years since Congress passed its pork-loaded infrastructure bill, so it is about time that something happens out there on America’s highways.
If infrastructure is indeed the dominating category in the growth of state spending, there is less reason for concern than if the increase was driven by an expansion in non-essential government functions.
As mentioned, there are some reasons for worry in this data release from the BEA. The biggest of them is the 15.9% decline in the construction of new homes. This category has declined six quarters in a row, conspicuously correlating with the Federal Reserve’s increases in interest rates.
A decline in home construction is always of concern, especially since it is a relatively labor-intensive industry. At the same time, with an inflation-adjusted $150 billion being spent on the construction of new homes, the second quarter of this year is not too bad compared to previous years. The top quarterly numbers from the Trump economy were just above $160 billion.
In other words, the decline has not been disastrous by any measure, but we should also not expect a rebound any time soon. It will not happen until household incomes catch up with the higher interest rates.
Another reason for worry is the apparent increase in volatility in GDP growth. Since the start of 2022, GDP growth has gone from a solid 3.5% in Q1 of 2022 to 0.9% in Q4 last year, to the most recent 2.7%. These swings, while not exceptional in any way, exhibit a bit more amplitude than there should be if the economy was on a solid long-term footing.
We can expect more stability when the Federal Reserve is done raising interest rates. Its most recent one came last week when the Federal Open Market Committee, FOMC, increased the benchmark federal funds rate by 0.25 percentage points. The funds-rate span is now 5.25-5.5%, which is a tad higher than what the economy can live with over time.
The rate hike was not unexpected, and the timing suggests that they are done for the year. It is better for the FOMC to deal one last punch to inflation than to have to ‘go back in’ if inflation does not come down as intended. With this hike, the FOMC can rest on its laurels and watch the consumer-price index slowly descend from 2.97% in June to the Fed’s target rate of 2%.
At the same time, by raising its rates now, the Fed has given its de-facto approval to the upward drift in interest rates on U.S. government debt. Up until recently, that upward drift was motivated by inflation, with investors demanding compensation for price hikes in order to give up their money for a fixed amount of time. However, while inflation is still a problem, it is by no means a major one. Investor expectations, as revealed in the inflation-adjusted TIPS segment of U.S. debt securities, have come down over the past several months. In October and November, TIPS investors expected U.S. inflation in the next few years to be 2.45-2.85%; in recent months those expectations have fallen to 2.1-2.3%.
For this reason, it is reasonable to conclude that the rising interest rates on U.S. debt are increasingly driven by worries among investors over the future solvency of the federal government. By giving its approval of such worries, even if it is a tacit approval, the Federal Reserve is also giving its pre-approval to a continuation of the upward drift in the interest rate that investors demand in order to hold U.S. debt, let alone buy more of it.
That upward drift could be the cause of a fiscal crisis. Hopefully, the Federal Reserve realizes this and stays away from further rate hikes.
