Economy Commentary
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This Is It. It Is, Isn’t It?

May 2022

No, it actually isn’t. “It” being the start of the recession that many have deemed inevitable. As we noted last month, Q1 2022 GDP was destined for weakness, at least under GDP accounting conventions, with inventories and net exports teaming up to, well, do a number on real GDP growth. In an environment in which nerves were already on edge, a weak headline print on the report on Q1 GDP was bound to play right into those fears. As it turns out, that headline print was even weaker than expected, with real GDP reported to have contracted at an annualized rate of 1.4 percent. Those already pre-disposed to do so took that headline print and ran with it, advancing their narrative of an all-but inevitable recession. The rest of us, however, found little to fret over in the report on Q1 GDP, the 8.0 percent annualized increase in the GDP Price Index being a glaring exception. In short, the contraction in real GDP in Q1 said more about GDP accounting than it did about the underlying health of the economy.

For instance, on an annualized basis, inflation-adjusted nonfarm business inventories increased by $185.3 billion in Q1. While that was a larger inventory build than we anticipated, it actually took 0.75 percentage points off the quarterly change in real GDP. Under GDP accounting conventions, the change in inventories from one quarter to the next enters into the calculation of the level of GDP, but it is the change in the change in inventories that matters in the calculation of the rate of change in GDP. As such, since the increase in nonfarm business inventories in Q1 was smaller than the annualized increase of $212.8 billion in Q4 2021, inventories went down as a deduction from the quarterly change in real GDP in Q1.

The hit from trade was even larger, with a substantially wider trade deficit deducting 3.20 percentage points from the quarterly change in real GDP in Q1. Global trade flows have been significantly distorted by supply chain and logistics constraints since the onset of the pandemic, which has wreaked havoc on the timing of exports and imports being booked. More fundamentally, the wider trade deficit reflects the U.S. economy being further along in its expansion than most of its foreign counterparts.

Though they combined to knock 3.95 percentage points off the quarterly change in real GDP in Q1, neither the smaller inventory build nor the wider trade deficit say anything meaningful about the underlying health of the U.S. economy. To us, the story isn’t that the build in nonfarm business inventories was smaller in Q1 2022 than that seen in Q4 2021, but rather that, despite persistent supply chain and logistics bottlenecks, we’ve seen two straight quarters of rapid growth in business inventories. As for the wider trade deficit, one thing that largely escapes notice is that just over half of imports into the U.S. are either raw materials, intermediate goods, or capital equipment used by firms located in the U.S. to produce final goods. Under GDP accounting conventions, however, these imports are treated as a deduction from GDP while in reality they are a complement to domestic production.

Largely overlooked in the Q1 GDP data was that combined household and business spending grew at an annual rate of 3.7 percent after adjusting for inflation. Real business fixed investment rose at an annual rate of 9.2 percent, powered higher by outlays on equipment, machinery, and intellectual property products (research and development and software). Business investment should remain a key support for real GDP growth, driven by replacement investment, investment in automation and technology, and continued strong spending on intellectual property products. Keep in mind that, in addition to supporting contemporary real GDP growth, business investment lays the foundation for faster longer-term growth by expanding the economy’s productive capacity.

Saying the headline print on the report on Q1 real GDP is misleadingly weak is not the same as saying all is well with the U.S. economy. As measured by the Consumer Price Index, inflation hit 8.5 percent in March and the upcoming April data will likely show another month of inflation over 8.0 percent. While the labor market remains solid, with another 428,000 nonfarm jobs added in April, labor supply constraints remain a hindrance to even stronger job growth while fueling rapid wage growth, some portion of which is being passed along by firms in the form of higher output prices. As for non-labor inputs, the Institute for Supply Management’s monthly surveys of the manufacturing and services sectors show input price pressures remain intense. At the same time, the latest round of shutdowns in China has further disrupted global supply chains, which could mean that goods price inflation will be higher and more persistent than had been anticipated. Finally, higher mortgage interest rates pose a threat to single family construction and sales, particularly in conjunction with the lofty pace of house price appreciation over the past several quarters.

Against the backdrop of elevated inflation and notably tight labor market conditions, the FOMC raised the Fed funds rate by fifty basis points at their May meeting, and in his post-meeting press conference Federal Reserve Chairman Powell stated that like-sized hikes will be “on the table for the next couple of meetings.” At the same time, Chairman Powell noted that 75-basis point hikes are “not something the Committee is actively considering” which, while not ruling out such moves, does set the bar for them considerably higher. Rather than taking comfort from this, market participants seem concerned that the FOMC may not be moving fast enough to get back to a more neutral policy stance.

Lurking as a wild card in the discussion of how far the FOMC will go in the current cycle, and how fast they will get there, is the Fed’s balance sheet. At the conclusion of their May meeting, the FOMC announced the Fed’s balance sheet will begin winding down on June 1, at a rate of $47.5 billion for the first three months and at a monthly rate of $95.0 billion thereafter. While the FOMC may hope that the balance sheet winding down will be little more than “background noise,” the reality could be less benign. Running down the Fed’s balance sheet could put upward pressure on interest rates and could add another degree of volatility in already volatile fixed income markets. To the extent either, let alone both, prove to be the case, the real economy will not be immune from the fallout.

Source: Bureau of Economic Analysis; Bureau of Labor Statistics; Institute for Supply Management

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