NEWS / Foreign Exchange

Real GDP Nearly Stalled in Q1, Improved Outlook for 2007 Tied to Fed Policy

Real gross domestic product (GDP) grew only 0.6% in the first quarter, after a 2.5% increase in the fourth quarter. The preliminary estimate is about half the advance estimate of 1.3% increase in real GDP. A sharp reduction in inventories (-$4.5 billion compared with $14.8 billion in the advance report) and stronger growth in imports (5.7% vs. 2.3% in the advance estimate) led to the significant downward revision of real GDP growth in the first quarter.

Final sales, GDP excluding inventories, grew at an annual rate of 1.6% in the first quarter after a 3.7% increase in the third quarter. Private sector final demand, the sum of consumer expenditures and fixed investment (business sector outlays and residential investment), advanced 2.1% on a year-to-year basis in the first quarter, representing a decelerating trend that began in the end of 2005 (see chart 2). The outlook for private sector spending is tied to the direction of Fed policy. If the Fed remains focused on waiting until core inflation readings are at or below 2.0% before dropping the funds rate, there is good chance for private sector spending to show additional deceleration in the quarters ahead.

There is sense of optimism that capital spending will rejuvenate economic growth back toward 3%. A large part of this confidence stems from expectations that corporate profits will lift capital spending. However, currently available data cast a shadow on these predictions. Corporate profits grew 1.2% in the first quarter following a 0.3% drop in the fourth quarter. On a year-to-year basis, corporate profits were up 6.4% in the first quarter following five quarters of hefty double-digit growth (see chart 3). This decelerating trend of profit growth is not supportive of a likely pickup in capital spending.

Incoming data about consumer spending in the second quarter point to annualized growth in the second quarter with at less than 2% in contrast to the 4.4% annualized increase in the first quarter. Residential investment expenditures are predicted to post another quarterly decline in the second quarter. All said, the sum of the three components of private sector spending will add to GDP in the near term, but their contributions will not be robust enough to raise the headline number anywhere close to perceived potential growth in the range of 2-3/4% to 3%.

The minutes of the May FOMC meeting were largely hawkish suggesting no change in the federal funds rate in the foreseeable future. However, if we are correct that growth in consumer spending is about to slow significantly, the FOMC may become less confident in its forecast of a sustained pick up of economic growth for the second half of this year.