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August 01, 2009

Second-Quarter GDP - The Parachute Has Opened
by Paul Kasriel

The Commerce Department's first guess at second-quarter real GDP has the U.S. economy contracting at only 1.0% annual rate compared to the first quarter's downwardly revised annualized contraction of 6.4% (previously reported as a 5.5% rate of contraction). On a year-over-year basis, real GDP was down 3.9% in the second quarter, the most severe year-over-year decline in the post-WWII era (see Chart 1).

Chart 1

In this advance estimate of second-quarter real GDP, the Commerce Department does not yet have June data for inventories or net exports. So, let's look at the data that Commerce thinks it has - final sales (i.e., excluding inventories) to domestic purchasers. The rate of descent here, too, has slowed - an annualized contraction of just 0.2% in the second quarter vs. a 4.1% rate of contraction in the first quarter. A step up in government expenditures - federal as well as state & local - played a big role in moderating the contraction in domestic final demand. As shown in Chart 2, real government expenditures rebounded with annualized growth of 5.6% in the second quarter. Real private domestic expenditures on final goods contracted at an annualized rate of 3.2% - still very weak, but not as weak as the first quarter's annualized contraction of 7.3%.

Chart 2

In the second-quarter rebound in real government expenditures we see the early spending effects of the federal fiscal stimulus program, not so much in federal expenditures, but in state & local government expenditures. As shown in Chart 3, real state & local government gross investment (i.e., infrastructure spending) soared to an annualized rate of 13.3% in the second quarter while real general operating expenditures were nearly flat. With state & local fiscal situations in dire straits, where did these governments get the funding to engage in so much investment, "gross" as it might be? Most likely directly from the U.S. Treasury or indirectly from the U.S. Treasury from "Build America" bonds - taxable bonds issued by state & local governments but with a Treasury rebate to the issuers. Also, state & local government operating, or consumption, expenditures likely would have been weaker had it not been for U.S. Treasury funds transfers to these government entities. Going forward, federal government nondefense gross investment expenditures are likely to grow rapidly rather than contract at the 0.9% annualized pace that they did in the second quarter. President Obama is urging federal agencies to step up the pace of actual spending of previously-authorized expenditures. Say no more.

Chart 3

There was reported a marked slowing in the rate of decline of business capital spending - on structures as well as equipment & software (see attached table for details). With regard to structures, I would expect the rate of decline to gather renewed downside momentum in the second half of the year. Commercial real estate cycles tend to be relatively long and severe. With commercial property vacancy rates rising and with commercial mortgage lending restricted, it is hard to see that the end of contraction in this sector is remotely near. I am less negative about the outlook for equipment & software spending, but again, with as much excess capacity as is being reported, it is unlikely that the contraction in this sector will end until the fourth quarter.

It takes a little over six months to finish a single-family dwelling once it is started. Single-family housing starts have increased in each of the four months ended June. Thus, residential investment expenditures are likely to continue contracting in the third quarter, before leveling out in the fourth quarter. But the third-quarter contraction is expected to moderate from the second quarter's 29.3% annualized rate of decline.

Despite stepped up government transfer payments to households and reduced federal tax withholdings, real personal consumption expenditures could not manage to post any growth in the second quarter. But the second-quarter annualized decline of 1.2% in real consumer spending was a relative improvement over the second half of 2008's annualized contraction of 3.3%. The federal government's "cash-for-clunkers" program, which is likely to be enlarged from $1 billion to $3 billion, will boost third-quarter motor vehicle sales. But this will be borrowing from future sales. With households still in a pinching pennies mode, with the unemployment rate headed higher and with lenders not exactly falling over themselves to advance households credit, real consumer spending may be nearing a period of stabilization, but likely is many quarters away from a shop-until-you-drop phase.

As we said at the outset, the Commerce Department does not yet have June inventories and net exports data. So, the advance report for these GDP components has to be taken with an even smaller grain of salt than the other components. With this proviso in mind, it was encouraging to see the annualized rate of contraction in real exports slow from nearly 30% in the first quarter to a mere 7% in the second quarter. With a number of developing economies experiencing economic recoveries, such as China, Singapore and South Korea, the change in U.S. exports might break into the plus-column by the end of this year.

Lastly, the volatile swing factor, private business inventories shaved 0.8 of a point off of second-quarter real GDP after buzz-cutting it 2.4 points in the first quarter. Detroit's bankruptcy woes played a role in the continued decline in private business inventories. GM's longer-than-usual summer shutdown this year might hold down seasonally-adjusted motor vehicle inventories in the third quarter, too. But one of these quarters, perhaps the fourth quarter of this year, darned near every business in America will decide to do a little restocking of the shelves, and real GDP growth will skyrocket. Investor beware.

In sum, the worst is over, but the best is not yet at hand. The imminent recovery will take hold not with some sustainable explosion in one sector or another, but because some hitherto really weak sectors will stabilize and/or grow a little.

In addition to providing us with its first guess at the economy's second-quarter performance, the Commerce Department also provided us with some of its new guesses as to how the economy performed in the years 2006 through 2008. As the data below show, economic activity in 2008 was a lot worse than Commerce had previously guessed it was. But a lot of you knew that already.

This revisionism on the part of Commerce is why I like other sources of data, such as the Institute for Supply Management (ISM). Other than annual updates of seasonal adjustment factors, the data provided by this source never get revised. Chart 4 shows that the ISM survey results indicated a very serious economic downturn was underway in 2008. And now the Commerce Department confirms it. I eagerly await what the ISM has to tell us about July economic conditions in its release on Monday, August 3.

Chart 4

Real Gross Domestic Product 2009:Q2 Advance Estimate

Key Interest Rates

Global Economic Data

Paul L. Kasriel, Director of Economic Research
The Northern Trust Company
Economic Research Department
Positive Economic Commentary
"The economics of what is, rather than what you might like it to be."
50 South LaSalle Street, Chicago, Illinois 60675

The information herein is based on sources which The Northern Trust Company believes to be reliable, but we cannot warrant its accuracy or completeness. Such information is subject to change and is not intended to influence your investment decisions.

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