Commentary

What Do the Big Q2 GDP Numbers Actually Mean?

Mickey Levy
By Mickey Levy | August 1, 2018 | 12:28 PM EDT

President Donald J. Trump (Screenshot)

Last week’s announcement of the second quarter (Q2) GDP numbers shows that the U.S. economy is in good shape. Real GDP advanced 4.1%, the fastest rate of growth since the third quarter of 2014. That puts average growth in the first half of 2018 at 3.1%.

This strong performance implies a big increase to measured labor productivity in Q2 that will significantly boost its growth trend.  Productivity-driven growth helps keep a lid on inflation and adds to longer-term productive capacity.

The GDP Report reflects strength in product demand:  real final sales to domestic purchasers—that is, private domestic consumption and investment spending-- increased by 3.9%. The pick-up in this metric bodes well for momentum entering the second half (H2).

Real consumption rebounded to a 4% annualized gain in Q2 after a disappointing 0.5% in Q1. The 2.25% average gain in first half (H1) consumption is somewhat disappointing in light of elevated confidence, the boost to real disposable incomes from the Tax Cuts and Jobs Act, and re-acceleration in job growth. However, the pick-up in momentum in Q2 – as well as high confidence, household net worth, and ongoing increases in employment and disposable income – point to solid consumption gains in H2.

Business fixed investment advanced by a strong 7.3% quarter-over-quarter, following up on a very strong 11.5% gain. This reflects a boost from the Tax Cuts and Jobs Act, deregulation, high confidence, and strong profits. Strong durable orders growth and optimistic businesses sentiment point to continued momentum in the near-term that will offset supply chain bottleneck and trade uncertainties.

Residential fixed investment declined for the second consecutive quarter in Q2. Housing activity is being held back by insufficient supply—there is a clear lack of inventory of existing homes for sale, which is outweighing the continued increases in residential construction and new home sales. I expect existing home sales to move sideways while housing starts and new home sales continue to rise with the healthy economy and labor markets. Favorable demographics also suggest demand for new housing units.  Importantly, new construction and home improvements add directly and significantly to GDP, while existing home sales are asset transfers that provide secondary effects to economic activity. 

 

Inventory investment subtracted a massive 1 percentage point from Q2 real GDP growth because of strong demand, as business production could not keep pace with strong product demand. Given the very low inventory-sales ratios across sectors, I expect business production to remain strong as firms strive to meet demand and rebuild their replenished inventories. Inventory investment should contribute positively to H2 GDP growth.

Net exports contributed a sizable 1.1 percentage point to Q2 real GDP growth, as the trade deficit narrowed, reflecting a robust 9.3% annualized increase in exports and a 0.5% rise in imports. Presumably, some of this increase in exports occurred as businesses tried to get ahead of the imposition of trade tariffs.  Accordingly I expect inventory building to add significantly to GDP in the second half of the year, while slower exports subtract a bit.  

Government purchases rose by 2.1% annualized, lifting its year-over-year gain to 1.2%. Government purchases will continue to contribute significantly to GDP growth in coming years due to the Bipartisan Budget Act of 2018, which will lift fiscal spending over the next couple of years.

While the closely followed personal consumption deflator rose 1.8% and the core PCE index rose 2.0% for the quarter, the chain-weighted price index rose 3.0%. To a large extent, this reflects hefty price increases in residential investment—higher home builder costs are being passed on to purchasers—and higher prices of exports.   

Overall current dollar spending in the economy was robust:  nominal GDP—real growth plus quality adjusted inflation—rose a robust 7.4%, lifting its year-over-year growth to 5.4%, the strongest since 2006. 

Here’s what to watch going forward: The low inventories suggest that businesses must ramp up production to meet solid demand; the Q2 spurt in export growth is most likely to moderate in coming quarters; and, in response to this strong productivity-driven growth and moderate inflation, the Fed will likely hike its policy rate twice more this year.

Mickey Levy is chief economist for the Americas and Asia at Berenberg Capital Markets, LLC and a member of E21's Shadow Open Market Committee (SOMC). The views expressed in this column are the author’s own and do not reflect those of Berenberg Capital Markets, LLC.

Editor’s Note: This piece was originally published by Economics21 at the Manhattan Institute.

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