Smith Faculty Opinion Article - October 28, 2005

Third Quarter Growth Stronger Than
Expected and Inflation Tame
By Dr. Peter Morici, Professor of International Business

Today, the Commerce Department reported today GDP grew at a 3.8 percent annual rate during the third quarter of this year.

Overall consumer spending held up, rising at a 3.9 percent annual rate, thanks mostly to strong July auto sales, and the housing sector did well expanding at a 4.8 percent rate. Business spending on nonresidential structures, new plant and equipment was up at a 6.2 percent annual rate but this was at a slower pace than the second quarter 8.8 percent. Within business investment, nonresidential construction was down 1.2 percent.

The trade deficit was not much of a drag because it did not grow very much in the third quarter; however, trade deficit is likely to increase considerably moving forward.

Inflation news was good. The price index for GDP jumped at a 4 percent annual rate but the core index was up a modest 2.2 percent, as compared to the second quarter rate of 2.1 percent. Coupled with the modest increase in the labor costs reported by the Bureau of Labor Statistics today, these data indicate that the recent surge in energy prices is not creating inflation throughout the economy. With energy prices falling in October, we can expect generally good news on inflation in the months ahead.

For the fourth quarter, several clouds are emerging on the growth front.

Consumer spending was largely driven by big auto sales in July, and since August auto sales have reversed direction. The housing sector is showing signs of cooling. Prices for existing homes have fallen below April levels. Although new home sales showed an up tick in September, this gain reflected in large measure a downward adjustment in August data, and new home sales have been generally flat in 2006. Much of the recent gain in real residential construction has been in building larger and more expensive homes, and downward pressures from falling existing home prices will cool new home construction in the months ahead.

The recent consumer boom was substantially powered by home equity loans and increases in credit card debt. Household spending has been exceeding income since June, and the pull back in housing values, credit card delinquencies nearing 5 percent and higher energy prices indicate the string is running out on consumer spending.

For the economy to continue expanding at 3 or 3.5 percent a year or better, business investment will have to pick up the slack, and the Fed will have to engineer an interest rate environment that permits a cooling of the housing sector without overly stressing consumers heavily in debt and business plans for expansion. Nonresidential construction was the weak link in the business investment in the third quarter, and the Fed should seriously consider the implications of further tightening on this sector.

Owing to recent strength in the dollar, continued Chinese intransigence on its currency policy and other disadvantages imposed on U.S. trade competing industries by foreign trade policies, the trade deficit will increase in the fourth quarter and once again tax growth and jobs creation.

Hurricane Katrina impacted on September employment resulting in the loss of about 250,000 jobs and the shutdown of the Gulf Ports and refineries. Katrina also took a bite out of durable goods sales and investment. It is now apparent that the full impacts of Hurricanes Katrina and Rita will not be seen until the fourth quarter. For example, these storms increased unemployment claims more that 450,000 over the last nine weeks, and Gulf infrastructure and energy supplies remain fractured.

The effects of the hurricanes on demand and GDP were not large in the third quarter, as those displaced were assisted by both governments and employers and continued spending. However, going forward, many citizens whose lives have been altered will have to trim spending and this will drag some on the economy.

Fed plans to raise interest rate, as anticipated to 4.5 percent, continue to pose substantial risks.

Although Katrina and Rita created some upward push on gasoline and other energy prices, these are receding, and inflation data for October should be good. In particular, gasoline prices have been falling and natural gas and heating oil futures have moderated. Consumer prices, less energy and food, will get some lift from energy pass through but this should prove small in comparison to the progress on gasoline and other energy prices. Core consumer prices should then recede in November. Overall the outlook for inflation is good for November and December.

In the third quarter, higher prices for imported oil weighed down consumer spending. In the fourth quarter falling home equity values, tightening credit conditions and the growing trade deficit will weigh down retail sales and new home construction. Raising interest rates too much could throw retail and housing sales into a tailspin and undermine the modest recovery in business spending on new investment. Falling durable goods orders and industrial construction further indicate the dangers of pushing interest rates too far.

Already prices for existing homes have begun falling throughout the country, stressing household balance sheets. Paper losses in housing values will cause consumers to reevaluate spending and savings habits, and discourage them from spending their entire paychecks. As consumers save more, new home construction will moderate and consumer spending will suffer.

The holiday shopping season promises to be decent but with lots of discounting early. Wal-Mart and Neiman Marcus will do well at the lower and upper ends but others catering to middle class customers face tougher sledding.

Fading housing values, rising credit card delinquencies and gas prices have all taken a bite out of retail sales, and prospects for holiday shopping are decent, not great.

Although the Fed is almost certain to raise interest rates on November 1 and December 17, the economic performance that emerges over the next three months will likely indicate more caution after that.

The prospects for both slower growth and moderating inflation indicate the Fed should pause in its march to push up interest rates to 4.5 percent. If it fails to heed the warning signs beneath todays generally good news, the Fed risks throwing the economy into a tailspin.