April 28, 2006 (GDP Byte)
GDP Report Shows Strong Growth, Higher Inflation
April 28, 2006
By Dean Baker
GDP grew at a 4.8 percent annual rate in the first quarter of 2006, bouncing back from a 1.7 percent growth rate in the fourth quarter. The strong growth was associated with a second consecutive quarter of relatively high inflation. The core (excluding food and energy) GDP deflator rose at a 3.3 percent annual rate after rising at a 3.4 percent rate in the fourth quarter. By comparison, core inflation was 2.5 percent in 2004 and 1.8 percent in 2003.
The main factor propelling growth in the quarter was a surge in consumption, which grew at a 5.5 percent annual rate. Consumption spending was unusually weak in the fourth quarter, due to a large falloff in car buying following record summer sales. The return of car sales to more normal levels in the first quarter gave a strong boost to consumption, adding 1.5 percentage points to GDP growth in the quarter. Other categories of consumption showed solid growth, with purchases of non-durable goods rising at a 5.4 percent annual rate and services rising at a 2.8 percent rate.
Investment grew at a 14.3 percent annual rate in the quarter, after rising at just a 4.5 percent rate the prior quarter. A 16.4 percent rise in equipment investment was the main factor in this growth, although investment in structures also rose by 8.6 percent.
Housing investment continued to rise, albeit at a modest 2.6 percent pace. Since inflation is more rapid in housing than elsewhere, this growth was sufficient to raise the construction share of GDP to a record 6.18 percent.
The foreign sector was again a drag on growth, subtracting 0.8 percentage points from the growth rate as the trade deficit hit yet another record of 6.17 percent of GDP. The most striking item on the trade side was the third decline in service exports in the last four quarters. The service sector is supposed to be an area where the U.S. is strong. The government sector added 0.7 percentage points to growth in the quarter, with most of this increase attributable to a 10.3 percent rate of growth in defense spending, offsetting a decline of 8.9 percent in the fourth quarter.
The 3.3 percent rise in the core GDP deflator continues a trend of gradually accelerating inflation. This trend has been driven in part by somewhat more rapid wage growth and also by higher energy costs. As the labor market has tightened, workers are better able to make up some of the decline in real wages that they suffered as energy prices ate into their paychecks. Wage growth is likely to continue to accelerate as the labor market tightens further.
One factor that is likely to receive considerable attention is the evidence of slowing productivity growth. While productivity growth had been very strong thus far in this recovery, productivity actually fell at a 0.5 percent annual rate in the fourth quarter. The non-farm business sector grew at a solid 5.8 percent rate in the quarter, but hours growth was also strong. Payroll hours increased at a 3 percent annual rate and the number of self-employed grew at a double-digit rate. Since hours growth will be close to 4.0 percent for the quarter, productivity growth will likely be under 2.0 percent. The negative productivity growth of the fourth quarter coupled with relatively weak growth in the first quarter could mean that we are now on a slower productivity growth path.
A combination of slower productivity growth and more rapid wage growth will lead to more inflationary pressure, which will virtually ensure that the Fed continues it path of tightening long past May. While continuing wage and job growth will sustain consumption, the impact of higher interest rates on the housing market will be a powerful offsetting factor. It is virtually certain that housing construction will trail off for the rest of the year, the big question is how quickly it declines. The other key issue for the economy will be the extent to which lower house prices affect consumption. With savings hitting a post-war low (the third quarter data was distorted by Katrina), there is much room for consumption to fall.
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.