October 27, 2006 (GDP Byte)
Third Quarter Growth is Slowest in Three and a Half Years
October 27, 2006
By Dean Baker
The economic slowdown continued into the third quarter with GDP growing just 1.6 percent, the slowest growth pace since the 1.2 percent rate in the first quarter of 2003. The biggest factor slowing growth in the quarter was housing. It declined at a 17.4 percent annual rate in the quarter, subtracting 1.12 percentage points from the quarter's growth rate.
Net exports were also a drag on growth, as the 7.8 percent growth rate in imports outstripped the 6.5 percent growth rate for exports, pushing the trade deficit to yet another record high. The deficit for the quarter was $810 billion (6.1 percent of GDP), as trade subtracted 0.58 percentage points from GDP growth.
Consumption advanced at a healthy 3.1 percent annual rate, boosted in part by an 8.4 percent jump in durable goods purchases. This was in turn driven by a 12.8 percent increase in car purchases, following a drop in the second quarter. Consumption growth is virtually certain to weaken in the fourth quarter and 2007 as consumers face greater difficulty in borrowing due to falling home prices. The ratio of mortgage debt to home values was already at a record high in the second quarter. As prices drop, this ratio will go still higher, and many families will no longer have any equity that they can tap. As borrowing slows, the savings rate should return to positive territory some time next year. (It was –0.5 percent in the quarter.)
Non-residential investment grew at a respectable 8.4 percent annual rate, adding 0.88 percentage points to growth. This growth was driven by a 14.0 percent growth rate in structure investment, following a 20.3 percent growth rate in the second quarter. It is likely that this burst in structure investment reflects pent-up demand created by the boom in residential construction. With the housing sector slowing, resources were suddenly freed up for non-residential construction, allowing for the extraordinary growth of the last two quarters. If this is the case, then growth in this sector is likely to fall in the quarters ahead. While overall investment growth is likely to remain positive, its impact on growth will be limited.
One implication of this report that is likely to get the Fed's attention is the new evidence of slowing productivity growth. The Labor Department's report last month that job growth in the establishment survey will be revised up by 800,000 for the period from March 2005 to March 2006 implies that productivity growth for this period will be revised down by approximately 0.6 percentage points to 2.1 percent. Productivity growth for the second quarter was reported as just 1.6 percent. With output in the non-farm business sector growing at just a 1.6 percent annual rate in the third quarter, productivity growth will likely be under 1.0 percent in the third quarter. While this slowdown is primarily cyclical, it suggests that the trend rate of productivity growth may be somewhat lower than is generally believed. That could cause the Fed to be cautious, lowering interest rates to combat the weakening economy.
The third quarter GDP report confirms widespread evidence of an economic slowdown driven by the end of the housing boom. Weakness in the housing sector will clearly persist for some time, as inventories of new and existing homes remain near record highs. Thus far, the decline in home prices has had little effect on consumption, which is still growing at a healthy pace. However, it is inevitable that the impact of falling home prices will start to be felt soon. Homeowners had been pulling equity out of their homes at more than a $700 billion annual rate, this borrowing will slow sharply in the quarters ahead. With slowing consumption adding to the impact of sharply declining construction, the economy will slow further in the fourth quarter and is likely to slip into a recession by 2007. The Fed will then face especially tough choices, as inflation remains somewhat higher than its target range, even at a point where the economy could badly use some additional stimulus.
Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C.
CEPR’s GDP Byte is published quarterly upon release of the Bureau of Economic Analysis' report on the Gross Domestic Product.