US growth stumbles

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19 Jun 2012
Kevin Logan, Chief US Economist

Kevin Logan

GDP growth appears to be decelerating in the US again, calling into question the sustainability of employment gains and the growth of corporate profits. The 6.5% rise in profits over the past year is down from 8.8% a year earlier and slower profits growth, after a lag of about two quarters, is usually associated with slower growth in investment spending.

This is one reason why we expect GDP growth to be restrained this year. We forecast GDP will expand at about the same pace as in 2011 – roughly 1.5% over the four quarters. That is well below the long-run annual average of close to 3% prior to the start of the financial crisis in 2008 and it is below our estimate of the economy's potential growth rate – about 2.25%.

The reasons for the subpar growth are well known. Household deleveraging in response to the loss of wealth caused by the housing boom and bust is constraining the expansion of consumer spending. Small businesses face tighter credit standards and state and local governments continue to contract their spending and their workforces.

After years of rising deficits, the federal government is now embarking on what is likely to be several years of fiscal austerity. And now the demand for US exports has slowed because of the deepening financial crisis in Europe.

Consumer spending accounts for 71% of aggregate demand in the US economy so the outlook for economic growth depends crucially on the outlook for household income and finances. Both are improving, but, at a pace we think will support only modest gains in household spending this year.

With debt deleveraging leading to a small decline in total liabilities, overall net worth has increased slightly. However, total wealth is still well below pre-crisis levels and the gain so far this year is not enough to give much of a lift to consumer spending.

The situation is only slightly better with respect to income growth. In real terms, it has decelerated sharply over the past year. However, most of the deceleration has been in non-wage income. Wages and benefits have grown at roughly 1% in real terms for the past year, reflecting moderate gains in overall employment and compensation.

Two important developments have slowed the growth of non-wage income. First, monetary policy and global investors' need for safe-haven assets have pushed US interest rates to record lows in the past year. Total interest income for households has thus declined. Second, there have been tight budget constraints among state and local governments plus a move toward budget austerity at the federal level.

In real terms, state and local government spending has steadily contracted for three years and there appears to be no let-up. Balanced budget laws give the states little choice but to cut spending further. Over the past year, the reduction by state and local governments has subtracted 0.3% from GDP growth when in more normal circumstances they might be adding 0.3% to the economy's growth by expanding education facilities and other government services.

A drawdown in "contingent" defence spending, mostly operations in Iraq, has accounted for a good part of the federal government's decline in real spending and caps on overall discretionary spending imposed by the Budget Control Act of 2011 account for much of the rest. For the year overall we expect the decline in government spending will be as much a drag on GDP growth as it was in 2011.

The situation is only slightly better with respect to income growth.

For the past three years, the core rate of inflation has oscillated between 1% and 2%. Rising energy prices were passed through to the core rate during 2011; now, their decline should tug inflation lower as the year goes on.

For the past three years, the core rate of inflation has oscillated between 1% and 2%. Rising energy prices were passed through to the core rate during 2011; now, their decline should tug inflation lower as the year goes on.

But there are a few other reasons to expect moderation in consumer price inflation this year. Import price inflation has begun to slow for consumer goods, partly because of the dollar's recent strength against other currencies and partly because of a slowdown in the growth of global economic activity that has caused declines in the prices of many raw commodities.

The expected moderation in inflation this year will be welcomed by policymakers at the Federal Reserve. It will justify their own forecasts for stable inflation close to 2% in the medium term and it may silence critics who have been predicting that inflation will accelerate because of the Fed's highly accommodative policy stance. Lower inflation will also reinforce expectations that the Fed funds rate will be held close to zero for an extended period.

This report must be read with the disclosures, analyst certifications and the disclaimer.