FedViews, by Reuven Glick, FRBSF: In the preliminary report on first quarter GDP, growth was revised down to 0.6% from 1.3%, largely due to greater inventory liquidation and greater imports than estimated in the advance report.
The report also showed weakness in residential investment. Carrying the economy forward in the quarter was continued strength in consumption spending. The downward revision to GDP led to a corresponding revision in nonfarm business productivity for Q1 from 1.7% to 0.7%.
Retail sales in May were very strong, which surprised many forecasters. Overall retail sales rose 1.4%, following a decline of 0.1% in April. Excluding vehicles, sales rose 1.3% in May after a scant rise of 0.1% in April. Going forward, consumption will face stiffening headwinds from high gas prices, mounting debt obligations as mortgage rates rise, and a squeeze on the equity wealth in their homes as house prices decline.
Housing market data for the past couple of months give very mixed signals about whether residential investment has reached bottom. In April, housing starts rose 2.5%, but permits were off significantly—8.9%—from the previous month. The picture reversed in May, with starts falling modestly and permits rising.
Home sales data likewise are mixed. In April, new home sales rose a surprising 16%, while existing home sales fell 2.6%. There is some evidence also that house prices have not only appreciated more slowly but have actually declined: According to the National Association of Realtors, existing house prices are down 0.8% from a year ago; the Case-Shiller index indicated a 1.9% decline over the year. Residential construction spending—down 14% over the past twelve months—clearly has been a drag on GDP growth, but it has been offset by private nonresidential and government construction spending, leaving total construction spending down only 2% over the past year.
Orders for nondefense capital goods (excluding aircraft), a proxy for investment demand, appear to be regaining momentum this quarter. In April, these orders rose 2.1% following a 4.6% jump in March.
The manufacturing sector enjoyed solid growth in April, rising 0.5% following a 0.6% increase in March.
The labor market continues to be robust. Employers added 157,000 jobs in May, bringing the average increase in jobs for the last three months to 137,000. The unemployment rate remained at 4.5% in May, unchanged from April.
Evidence from retail sales, nonresidential and government construction spending, and manufacturing activity provide confidence that growth will rebound to above 3% in the second quarter, particularly as inventories are restocked. After the inventory swing ends, growth is expected to slow in the second half of the year. A downside risk to this forecast is that weakness in the housing sector could become more severe and persistent than expected. An upside risk comes from improvement in net exports due to solid growth abroad.
Inflation has been coming down recently. Over the past 12 months, inflation for the core personal consumption expenditures price index fell from 2.4% in February to 2.1% in March to 2.0% in April. (The core CPI fell from 2.7% in February to 2.5% in March to 2.4% in April to 2.3% in May.)
We expect inflation to hover around 2% in the quarters ahead. Risks to the inflation outlook include tight labor markets and low productivity, possibly leading to upward pressure on wage rates.
Long-term interest rates rose significantly; for example, 10-year Treasuries are up roughly 50 basis points since the last FOMC meeting. Expectations of higher inflation explain only a minor amount of this rise, as TIPS (Treasury inflation-protected securities) have risen by almost as much. Rather, the jump in nominal rates mainly reflected an increase in real rates related to expectations of a stronger U.S. economy and possibly of stronger economic conditions abroad. Financial markets no longer expect the FOMC to cut the fed funds rate this year, as evidenced by the basically flat fed funds futures path.
In recent years, burgeoning trade deficits have been a drag on the U.S. economy, reducing annual GDP growth by almost one-half percentage point on average.
Reversing this development requires some combination of depreciation of the dollar and stronger foreign demand, both of which we have seen to some extent. A weaker dollar tends to dampen U.S. imports by making them more expensive to U.S. consumers, while boosting U.S. exports by making them more competitively priced abroad. The broad dollar has fallen by roughly 20% since its peak in the second quarter of 2002.
However, this exchange rate adjustment has apparently not passed through one-for-one to U.S. consumers, as non-oil import prices have risen by only about 10%; one explanation is that foreign producers are afraid to lose market share in the U.S., so they try to avoid raising prices.
In addition, foreign growth has exceeded U.S. growth by an increasing margin, particularly in 2006 and 2007, with strength not only in most developing countries, but also in industrial economies, such as Japan and Europe. Taken together, these developments should give a lift to U.S. net exports, making them a significant upside factor to the GDP growth outlook.
