Growth Rebounds

Real GDP growth rose a more-than-expected 4% in the second quarter, after falling a less-than-previously reported 2.1% in the first quarter. The forecast was for a 3% rebound in growth. Benchmark revisions, which include more complete data, helped to reduce the drop in the first quarter. Almost all of the “unexpected rise” in growth in the second quarter came in a sharp increase in inventory accumulation. The rise in inventories alone accounted for nearly 1.7% of the in 4% increase economic activity. Some of this reflects a catch-up in activity following harsh winter storms and a drawdown of inventories in the first quarter. The estimate is high, given underlying data we have on the quarter for inventory building, but it is admittedly more consistent with the upswing in employment and manufacturing activity that we have seen in recent months. If I were given the latitude to estimate on the high side when compiling this data, this is a place you could easily put what appears to be an economy that was growing more rapidly than the reported data were suggesting.

Other gains we saw were fairly broad based and more in line with expectations. Consumer spending bounced back with strong gains in big-ticket spending; vehicle purchases were particularly strong, once consumers emerged from hibernation and replaced old and damaged cars. Pent-up demand and insurance payouts played a role in supporting spending on vehicles and parts this spring as a lot of vehicles were destroyed in accidents during winter storms. Spending on services, however, remained weak and continued to slow from the tepid pace of the first quarter. This no doubt has to do with distortions created by the Affordable Care Act and how that has played out as an increase in spending, but less than many had hoped.

Nonresidential investment also came back as businesses loosened their purse strings a bit. Investment in new equipment was particularly strong, which is a welcome trend if it can be maintained. Up until recently, much of the rise in business investment we have seen has been devoted more to repairs than new purchases of existing equipment. New purchases tend to correlate more with capacity expansion. Indeed, spending on new structures also regained some momentum during the quarter.

The housing market was a plus instead of a drag on growth as the weather improved. Gains remained too concentrated in multi- instead of single-family construction, however, and were still small given the losses in the fourth and first quarters. This has become more of a concern to the Federal Reserve in recent months and will likely be one of the few downside risks laid out in the assessment of the economy released later today. (The drop and then slowly rebounding home sales we saw in the wake of last summer’s taper tantrum were a particular disappointment for doves on the Fed.)

Exports also bounced back after disruptions to transportation and manufacturing activity created by unusually harsh winter weather. The overall trade deficit, however, widened and was a drag on growth as we imported more rapidly than we exported, as consumers spending and investment came back.

Finally, the government sector showed mixed results, with federal spending continuing to contract, in both relative and absolute terms. State and local government spending snapped back and is expected to provide more of a tailwind than a headwind for growth going forward. This marks a sharp shift in the economy from recent years when draconian cuts at the state and local levels were dampening employment gains.

Growth in the first half of the year now looks to have averaged about 1%, which is not terrific, but better than we thought, going into these figures. The rise in inventories makes our 3% average on the second half of the year a bit harder to reach; the jury is still out on whether the harsh weather was the only factor holding back growth at the start of the year. We can breathe a little easier today, however, than yesterday.

Bottom Line: The benchmark revisions showed more growth than was initially reported for the first half of the year, which is encouraging and more in line with the improvement in employment. The sharp increase in inventories could be a bit worrisome if consumer spending and investment don’t pick up at a faster pace over the summer. The recent increases we have seen in employment, however, suggest that we will be able to maintain a 3% pace in the second half of the year, which will put growth on a fourth-quarter-to-fourth-quarter basis at about 1.8% pace, which isn’t great, but not a disaster given the disruptions we saw at the start of the year.

Federal Open Market Committee (FOMC) members are expected to keep policy on cruise control with their decision to taper today by trimming another $10 billion from their purchases of mortgage-backed securities and Treasury bonds at the end of their meeting today. There will also be some good news as the Fed acknowledges recent improvements in both employment and inflation that bring the economy closer to their goal for a broader healing of economic conditions. Tensions between hawks and doves are expected to intensify, however, as doves remain concerned that the housing market is still lagging and that those gains in employment and inflation are still not enough to declare victory. Too many workers remain marginalized by the lackluster nature of the recovery, which continues to show up in lackluster wage growth and the preponderance of low-paid jobs in the employment data.

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