The economy was strong in the second quarter – indeed somewhat above our expectations. But some of this strength was from one-time anomalies, and as a result our forecast is only a little changed.
NIPA Data
The release of advance data on economic activity during the second quarter also included revisions to previous data. For the period since 2012 output growth was unchanged at 2.2%. However, for the most recent quarter (2018Q1) the revisions added 0.2% to growth. The revisions were more significant on the income side of the accounts, where personal income levels were revised upward substantially.
Compared to our recent forecasts the new data for the second quarter are mostly encouraging. Our May estimate for real GDP growth was 3.4% while the actual number was 4.1%. For final sales (leaving out change in inventories) the difference was over 2% with an actual value of 5.1%.
At a disaggregate level the second quarter was a mixture of strength with touches of weakness, and a couple of anomalies. The strength encompassed consumption (up 4%), business investment in intellectual property (+8.2%) and in structures (+13.2%), and federal defense spending (+5.5%). On the weak side were investment in equipment (up just 3.8%) and especially housing (down 1.0%). The anomalies were the two sides of the trade account: exports rose a huge 9.3% while imports were nearly flat at +0.5%. The former was due in large part to a surge in soybean shipments to China presumably to beat their retaliatory tariff. Given the strength of domestic demand, the import result is a puzzle (perhaps also in some way related to actual or impending tariffs).
A final second quarter item worth mention is the significant decrease in inventories ($27.9b). A positive explanation is that domestic demand caught producers unprepared leading to the drawdown of inventories. This could imply higher future output levels as they play catch-up. Another (more neutral) possibility is that it is a mirror image of the two trade anomalies mentioned above. A final (more ominous) interpretation is that business did not keep up with demand due to capacity constraints, which if true could make future gains in output increasingly hard to come by.
Overall, the NIPA data suggest that the economy entered the second half of the year with substantial momentum. Growth was strong, and except for housing broadly based. As is usual the primary components were consumption and business investment. The revisions to income suggest that consumption close to that in the second quarter is sustainable. On the business side, equipment purchases were disappointing, but total investment was solid.
Recent Data
Recent monthly data continue to be mostly positive, with one puzzling exception and one slightly ominous reading.
The latter is the ISM indexes for July, which both went down. The manufacturing index dropped by over 2 points; the non-manufacturing measure by nearly 3.5. Since both indexes remain at high levels, this is not terribly concerning. What was ominous was the number of respondents who mentioned negative effects of tariffs on their business, especially in manufacturing.
The puzzling negative report was a large decline in June housing starts, accompanied by a second consecutive decrease in building permits. The puzzle is that on a fundamental basis (household formation, still low financing costs) housing should be experiencing growth, but so far the data show no signs that it is.
On the positive side, industrial production bounced back nicely in June after a May decrease. June numbers for consumer spending were solid, as was growth in real disposable income. So far this year the latter has been growing at a 3.7% annual rate. Consistent with this, consumer confidence remained at a very high level in July.
Finally, the July employment report was mostly good. In the household survey unemployment dropped a tick to 3.9% and the participation rate remained at 62.9%. Total employment from the establishment survey was up 157 thousand, somewhat below expectations. But 13 thousand of the shortfall was from a decline in government jobs, all and then some at the local level. And another 30 thousand or so was due to the closure of Toys R Us outlets. As has consistently been the case in recent months there were strong job gains in the construction, manufacturing, business and professional, and health care sectors.
Except for the housing data, all these data are consistent with our continuing strong outlook for the immediate future.
Baseline Forecast
As can be seen in the chart, our new forecast is a little stronger through 2019:1 than in May (3.8% versus 3.4%). However virtually all of the difference comes from higher inventory accumulation, a response to the inventory decline in the second quarter. Leaving inventories aside our forecast scenario has growth over the next three quarters of 3.1%, slightly below our outlook three month ago.
And that scenario is in large part quite similar to the actual experience of the past year. In particular it rests on continued strength in consumer spending and in business investment. The major difference from the recent past is a significant boost from the federal government in line with the budget deal passed earlier this year. This increase is offset by an increase in the trade deficit of similar magnitude.
In the labor market we expect employment growth to continue at just above 200 thousand per month through early next year. This is quite close to the actual result over the past year and to our forecast in May. Starting in mid 2019 we expect job creation to decelerate over the next couple of years to about a 130 thousand rate, which is the level we think is consistent with long-run labor force growth.
A few additional aspects of our forecast scenario warrant mention. First, we have crude oil prices averaging about their current level for the next several years. Second, we have the Fed raising rates two more times this year and then three times in 2019. The federal funds rate stabilizes at about 3.3% in 2021. Adjusting for inflation at about 2.6%, this leaves the real federal funds rate below 1%, which we view as still an accommodative situation .
Summary
The economy has been doing well over the past five quarters, and our model says that the favorable results will continue. Indeed, we expect growth to accelerate somewhat over the next year. This growth is solidly based, resting on continuing good growth in consumer spending (based on rising income from a tight labor market), business investment (driven by tax reform and deregulation), and strong federal expenditures (from the stimulative budget deal).
We have three concerns about this optimistic outlook. The least significant is the lack of growth recently in the housing sector. If this continues it would reduce our GDP forecast by about 0.1%.
Our second concern is that the growth our model projects could be too much of a good thing. The labor market is tight with unemployment at its lowest in five decades. But our forecast has strong employment growth. It also has productivity increasing at more than double its rate over the past decade. If either of these optimistic conditions proves false, it would raise the prospects of inflation probably beginning in 2019.
Finally, there is the tariff situation. There is an increasing amount of anecdotal indications that it is having negative effects. A full-blown trade war last occurred before World War II. That time the result was not good. But so far there is nothing concrete in the actual data. And it is actual data that drives our forecast .