October 30, 2003
Strong growth only sustainable with labor market recovery
The economy grew 7.2% in the third quarter of 2003, its fastest pace since the first quarter of 1984, the Bureau of Economic Analysis (BEA) reported today in its advance release of gross domestic product (GDP) data. Underlying this growth was a surge in consumer spending (fuelled by tax cuts and a mortgage refinancing boom) and by a large increase in business investment. In addition, a declining trade deficit and moderate increases in government spending helped fuel the economic growth.
Consumer spending advanced at 6.6% in the third quarter, its highest rate in six years. Spending on consumer durables, such as cars, was particularly pronounced, with 26.9% growth compared to 7.9% in spending for non-durable goods, such as clothing or food.
Spending in the residential housing sector had its strongest showing in more than seven years. Household expenditures for new home purchases, construction, and renovation grew by 20.4% in the third quarter.
The strength of consumer spending rested on tax cuts and mortgage refinancing. A one-time tax cut boosted disposable income by $100 billion, which allowed after-tax income to grow at a 7.2% rate even as before-tax income rose by just 1.0%. Real wage and salary income actually fell by 0.1% in the quarter. And although long-term interest rates rose at the end of the second quarter, the refinancing boom extended into the third quarter due to “lock-down” periods for mortgage applications in which interest rates are fixed for mortgage applicants for 45 to 60 days.
The trade deficit shrank from its record high in the previous quarter. Net exports shrank by an annualized $23.5 billion in inflation adjusted terms, the first decline for net exports since the first quarter of 2001 and their largest inflation-adjusted decline since the fourth quarter of 1996. The improving trade deficit was due to a 9.3% rise in exports and by the fact that imports, with just 0.1% growth, remained virtually unchanged.
The surprising decline in the trade deficit amid strong domestic demand is related to a decline in inventory investment. Inventory investment declined by an annualized inflation-adjusted $18.4 billion in the third quarter. Because inventory investment declined, imports did not rise, despite strong economic growth. However, it is likely that both inventories and imports will rise again in the near future, contributing again to the possibility of a widening trade deficit.
Another factor that may have contributed to the improving trade deficit is the continued weakness of the dollar. The dollar’s value fell by 9% from February 2002 to June 2003 and remained relatively constant throughout the third quarter. Since changes in the dollar’s value don’t affect the trade deficit until about 12 to 18 months later, the third quarter decline in the trade deficit may be the fruit of the slow fall of the dollar over the previous 15 to 18 months.
The recovery in business investment continued for a second quarter. Business investment grew by 11.1% in the third quarter, after rising by 7.3% in the second quarter. The increase was driven by a 15.4% surge in business spending on equipment and software, which also offset a 2.4% decline in business spending on structures, such as plants and offices.
After an extraordinarily high 25.5% surge in federal government spending in the second quarter, federal spending grew only by 1.4% last quarter, with defense spending remaining unchanged but spending outside of defense increasing 4.1%. Budget woes at the state and local level kept growth at a modest 1.3% for the third quarter.
In summary, the recovery received a welcome boost in the third quarter, as all sectors of the economy expanded. Consumption, residential housing, and business investment for equipment and software lent a helping hand to the highest growth rate in almost 20 years. However, many of the causes underlying this growth are temporary: one-time tax cuts lifted disposable income; mortgage refinancing increased household spending; and a decline in inventories contributed to a lower trade deficit. To make the recovery sustainable, future household spending needs to be fuelled by income growth, which requires a recovery of the labor market, and further shrinking of the trade deficit, which requires a sustained decline in the value of the dollar.
The Economic Policy Institute GDP PICTURE is published quarterly upon release of the Bureau of Economic Analysis’ quarterly GDP report.
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