January 27, 2006 (GDP Byte)
Weak Consumption Depresses GDP Growth
January 27, 2006
By Dean Baker
The economy grew at just a 1.1 percent annual rate in the 4th quarter, its slowest rate since the 4th quarter of 2002. The main factor depressing growth was a weak 1.1 percent rise in consumption expenditures, the slowest growth rate in consumption since the 2nd quarter of 2001. A surge in the trade deficit subtracted 1.2 percentage points from growth in the quarter, although this was offset by an increase in inventories that added 1.5 percentage points to growth. Final sales (which exclude inventories) actually declined in the quarter at a 0.3 percent annual rate, the first drop since the first quarter of 2002.
While the data for the 4th quarter appear weak, much of this is actually attributable to a reversal from unusually strong 3rd quarter numbers. For example, a surge in car sales added 0.5 percentage points to 3rd quarter GDP growth. The slump in 4th quarter sales reduced growth by 2.1 percentage points. Similarly, defense spending added 0.5 percentage points to growth in the 3rd quarter, while subtracting 0.7 percentage points in the 4th quarter. In this sense, much of the 3rd quarter growth was effectively borrowed from the 4th quarter. The 2.6 percent average growth rate for the two quarters probably gives the best estimate of the current state of the economy.
Of course, even a 2.6 percent rate is substantially lower than 3.6 percent growth in the fist half of 2005 or the 4.2 percent growth in 2004, and there are reasons for questioning whether even this rate will be sustained. While wage and job growth seem to finally be on a healthy path, it is likely that the pace of borrowing will slow in the months ahead due to slower house price appreciation. This means that consumption is likely to grow less rapidly than the pace of income growth. While this is essential (the baby boom cohort must save more for retirement), it is likely to mean that consumption growth in 2006 will be far below the 3.9 and 3.6 percent rates for 2004 and 2005, respectively.
Recent data also indicate that housing construction has peaked and will be heading downward. This component added nearly 0.5 percentage points to GDP growth in 2005. The biggest disappointment in the 4th quarter is the weak performance of investment, which grew at just a 2.8 percent annual rate. In order to sustain a healthy pace of growth in 2006, investment will have to grow at a strong double-digit pace.
It seems likely that the trade deficit will rise further in 2006, as imports continue to swell. The trade deficit subtracted 0.3 percentage points from GDP growth in 2005. It is likely to subtract at least that much from growth in 2006.
In the 4th quarter, the GDP price index and the core index (excluding food and energy) rose at 3.1 percent and 3.0 percent annual rates, respectively. For the year, the overall index rose 2.8 percent, while the core index rose 2.7 percent. Inflation in the core index continues to edge upward, from 2.5 percent in 2004 and 1.8 percent in 2003. Productivity growth for the 4th quarter will be approximately -0.7 percent, which may spur inflation concerns. Here also, it would be appropriate to average growth for the last two quarters, although the resulting 2.0 percent rate is still relatively weak.
With the housing market topping off, if not actually declining, growth is likely to be substantially lower in 2006 than most economists have projected. (It is worth noting that almost all economists also projected strong growth in 2001.) While the economy is currently experiencing healthy job and wage growth, the falloff in borrowing against home equity will depress consumption growth. Furthermore, wage growth is likely to spur the market's fears of inflation (especially in a context of slowing productivity growth). This would push mortgage interest rates higher, further depressing housing prices and residential construction. It is still too early to say that the housing bubble is deflating, but the evidence is certainly growing that the process may have begun.
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.