Economic Growth Slows in 1st Quarter

The Bureau of Economic Analysis released their report of economic growth and it was disappointing.  Even though there was 1.8% growth in real gross domestic product, we typically want to see a figure above 3%.  While I agree that we can attribute some of the slower growth to rising gas and food prices, one must also recognize the impact of large government spending cuts, along with worse than expected weather conditions across many regions of the U.S.

It is true that there has been an increase in inflation over the last quarter, but it was not significant.  The Federal Reserve Bank of Cleveland reports trends of various inflation measures.  Their first measure of the Consumer Price Index (CPI) looks at prices of all items, including food and energy.  When calculating quarterly inflation rates, including food and energy, from the 4th quarter of 2010 and 1st quarter of 2011, we see that it increased slightly from 1.27% to 2.13%.  If you exclude food and energy prices, then the effect is even more moderate with quarterly Median CPI increasing from 0.6% to 1%.  As a guide, most economists actually want some form of inflation with the consensus being around 1-2% as healthy because it allows businesses to increase revenues and create jobs.

Having said that, I do expect inflation to play a more significant role in dampening economic growth in the second quarter.  Usually, gas and food prices are volatile in that there is much upward and downward movement each month.  However, both have been trending upward consistently.  If the trend continues over a long period of time, then we should expect people to be more cautious about their spending habits.  Additionally, it is also expected that businesses will eventually have to pass along their increased supplier costs from higher commodity and energy prices to the consumer in the form of higher prices.  Right now, a sluggish labor market and tenuous recovery are making businesses reluctant to raise prices across the board.

One might have heard pundits say that raising taxes during slow economy is an ill-fated policy, but they neglect to add that cutting government spending also damages the economy, too.  There are actually four components to economic growth:  consumer spending, business investment spending, government spending, and net export spending.  Of those four categories, only government spending actually witnessed a decline from last quarter.  In fact if you took out government spending, the economy would have grown by 2.89%, which would have approximated historical norms.  (Note:  Refer to Table 2. Contributions to Percent Change in Real Gross Domestic Product.)

The federal and state governments funds programs that sustain jobs in all regions of the U.S.  Referring to the federal level, national defense, services, and infrastructure spending impact multiple private businesses that have contracts in place.  In particular, there was a decline in defense spending, along with funding from the stimulus package ending which contributed a drop of $30 billion.  Portions of that spending would have gone toward economic growth.  On the state government side, we are seeing both a reduction in services and personnel as budget constraints are causing expenditures to decline at a rapid rate.

Another factor that should be pointed out is the abnormally bad weather experienced in many segments of the U.S. market.  In particular, the Midwest, Northeast, and Southeast suffered through winter storms that kept consumers at home.  That could be one factor causing the growth rate of personal consumption expenditures to decline, rather than rising prices.  Surely, a sluggish labor market and continued weakness in residential real estate are both relevant factors.

In conclusion, the threat of a double-dip recession remains small despite the lethargic economic performance.  However, this should be a cautionary tale about the impact of drastic cuts to the federal government spending before an economic recovery is able to gain steam.  Given the mandate to balancing budgets, most states do not have the same level of flexibility, so their options are more limited.  When achieving deficit reduction which will provide future benefits in the form of lower interest rates and greater credit access, a more balanced approach where deficit reductions are spread out over a longer period of time might be in order.

Inflation remains a concern and might even have a more negative impact on next quarter's economic growth.  The combination of poor global weather and the Federal Reserve's stance on monetary expansion are driving inflation risks up.  Currently, the Federal Reserve is reluctant to unwind their quantitative easing program which is aimed at keeping money flowing through the system or raise the federal funds rate.  Either policy would slow inflation, but it would come at the cost of higher unemployment.  Since labor markets are still operating at below capacity, one can see their reluctance in pursuing that route.  However, inflation risks are still moderate now, so it is not expected to unduly affect economic growth in the near future.

Learn Why Labor Market Is Gaining Steam

The U.S. job report was very favorable in March and exceeded expectations.  While the unemployment rate only dipped a tenth of a percent to 8.8%, it was encouraging to see 216,000 new jobs.  That occurred despite further contraction of government jobs with the private sector adding 230,000 positions.  Ideally, we need to see a consistent trend of job growth closer to 300,000 jobs added per month to revert back to pre-recession levels, but it should be noted that this figure is the highest since May 2010.  We can attribute most of these gains to increased economic activity from exports, business investment, and consumer spending.

A boost in exports is always favorable to job creation.  Exports are goods and services produced in the U.S., but sold abroad.  There is usually a direct correlation between exports and job creation and has been a point of emphasis for the Obama administration and the U.S. Federal Reserve.  Over the first two months of 2011, the U.S. totaled $286.1 billion in exports of goods and services, which is an increase of 14.8%.  During this time period, we have seen the trade deficit increase by 7.4%, but that's actually natural given a rich country like the U.S.  One of the reasons why China continually runs trade surpluses is that its home economy is so poor.  Therefore, our focus should be placed more on the level of exports and its upward trend is promising.

Business investment trends are an important indicator on the future health of labor markets.  Before jobs can be added, firms must be confident that the economy is improving.  Even though many Americans remain frustrated with the sluggish job market, business optimism has been on the rise.  According to the Conference Board, CEO confidence index is up 12 points to 62 from 50.   This is a quarterly survey given to key business leaders to assess their optimism of the U.S. economy.  It should be noted that any reading above 50 should be construed as more positive than negative.

To a lesser degree, consumer spending remains relatively good.  Before firms decide to expand payrolls, they need revenues to increase and this is enhanced when consumers open up their pocketbooks.  According the economic snapshot complied by the Atlanta Federal Reserve, we see that real personal consumption expenditures (real PCE) rose by 0.3% in February compared to last January.  While it should be noted that the rate of increase in real PCE between February 2010 and February 2011 (+2.5%) has fallen slightly when compared to January 2010 and January 2011 (+2.7%).  There is concerned whether this will continue because the Consumer Confidence Survey plummeted 8.6 points to 63.4 in March, according to the latest report from the Conference Board.  Concerns about gas and food prices are obviously impacting this figure and might negatively impact future spending.

Overall, we should be encouraged by the new labor report, but we must also recognize that turbulent tailwinds might be on the way.  Consistent progress in economic activity is finally bearing some fruit with job creation.  As we have mentioned before, there is always a lag between an economic recovery and an improved job market.  Having said that, global events can reverse any gains, so we must carefully monitor events in the Middle East, Japan, and areas across the world.  Political turmoil, weather, and public policy initiatives can all play a role in expanding or constricting the U.S. labor market.