GDP Clocks In at 3.4%

The 2Q2007 advance GDP number was released today by the Bureau of Economic Analysis. At 3.4% it was above economist expectations, but it is still subject to revision. This is definitely a stronger number than in Q1 when the BEA revised GDP down to 0.6% from 0.7%. Combined, the economy grew at an annual rate of roughly 2% during H1. This is below trend growth and definitely falls into the 'growth recession' range. Here are the important details from the report:

The price index for gross domestic purchases, which measures prices paid by U.S. residents, increased 3.9 percent in the second quarter, compared with an increase of 3.8 percent in the first. Excluding food and energy prices, the price index for gross domestic purchases increased 1.7 percent in the second quarter, compared with 3.1 percent in the first.

Real personal consumption expenditures increased 1.3 percent in the second quarter, compared with an increase of 3.7 percent in the first. Durable good increased 1.6 percent, compared with an increase of 8.8 percent. Nondurable goods decreased 0.8 percent, in contrast to an increase of 3.0 percent.

The price data was good news because core inflation appears to be moderating as the Fed expected. This may give the Fed the flexibility to squeeze in a rate cut later this year if necessary. In fact the futures markets are predicting one rate cut by December.

The Real PCE numbers and durable goods numbers were dismal however and if consumers and businesses continue to slow spending that would have a severe negative impact on the economy. Taken as a whole todays report contained mostly good news, although some, including Nouriel Roubini remain quite pessimistic about H2.

Should We Be Concerned about the US Consumer?

In the past few weeks former Fed chairman Alan Greenspan, Warren Buffett's sidekick Charlie Munger and hedge fund manager turned retailer Eddie Lampert voiced their concerns about weakness in consumer spending. I share their concern. Here is the case made in words and graphs.

1. Why We Care About Consumption: Consumption as a share of GDP has been slowly rising for years. Today consumption makes up roughly 70% of US GDP and a full 20% of the global economy. As such, weakness in US consumption has a greater impact on our economy and indeed the world economy than any other factor. Even a modest pull back in consumption will have ripple effects the world over:
In Q12007 this effect has been even more profound. Consumption is quite literally the only component of GDP that had a significant positive impact (click to enlarge):
2. The Real Estate Threat: The most direct assault on US consumption comes from the housing market, directly through the role of construction and indirectly through the wealth effect and mortgage equity withdrawals (MEW). The construction data is not rosy. Home builders have begun to lay off workers and warned on earnings. The housing start/permit data is very straightforward:

The wealth/MEW data is a little more difficult to gauge. Combined the Dallas Fed estimates that a $100 increase in home equity leads to between a $6 and $9 increase in long run consumption. Of that perhaps $2.50 - 5 may be immediate consumption. In April Greenspan and Fed Economist James Kennedy released a study estimating that MEW made up 4% of Personal Consumption Expenditures in 2006, which is in line with the Dallas Fed number. Whatever the actual number is, we know that it is significant. Because this issue is so hotly debated and so difficult to forecast it is difficult to say just how badly consumption may be hurt by home price declines. At the very least it should be clear that home price and home equity declines will probably not lead to higher consumption. The sheer volume of the MEW effect can be seen below:

3. Food and Energy Inflation: The other great threat to the US consumer is inflation, specifically increases in food and energy prices. The "core inflation" that the Fed is so fond of strips out food and energy, making it a useless number when measuring the impact on the average consumer who eats food three times a day and gets 12 miles per gallon driving to work in their new SUV. If you dig into the CPI data from March you'll find that although core inflation was a relatively innocuous 2.3%, over the last three months the energy component inflated at a 22.9% CAGR and food at a 7.3% CAGR. Over the past three months, inflation as measured by CPI was 4.7% and in March alone the figure was 7.5%. The bottom line is that inflation has picked up in recent months and has exacerbated the problems facing consumers. Much of the inflation is coming directly from retail gas prices and it is fairly easy to see why, check out the graph of retail gasoline prices over the past 6 years (click to enlarge):


4. Evidence of Weakness: April was the first month that weakened consumption actually started showing up in the numbers (Barry Ritholtz has been giving us anecdotal evidence for months). The retail sales data released on Friday showed an unexpected decline of 0.2%, the first decline in 7 months. Retail sales make up about half of consumption.

While the outlook is not good the US consumer is incredibly resilient. Upcoming data should give us some insight into how the US consumer is faring.

The Week Ahead: Key Economic Releases

1. CPI Data: Tuesday May 15th
2. Housing Starts/Permits: Wednesday May 16th
3. Consumer Confidence: Friday May 18th