Blowout third quarter GDP
Will it keep the Fed in play?
Gross domestic product (GDP) rose by a much stronger-than-expected 4.9% annualized rate in the third quarter, the economy’s largest quarterly gain since the 7.0% increase in the fourth quarter of 2021. The surge more than doubled the 2.1% quarter-over-quarter (q/q) increase in this year’s second quarter. For comparison, the Atlanta Fed’s GDPNow projected 5.4%, Bloomberg 4.5%, Blue Chip consensus 3.5% and Federated Hermes 2.7%.
What happened? A surge in personal spending accounted for more than half of the robust performance. At 4% q/q, it was the largest increase since the same gain in the fourth quarter of 2021. Inventories soared by $80.6 billion in the third quarter, as companies bulked up to prepare for the United Auto Workers (UAW) strike. Government spending also rose, split between federal defense and state & local. Finally, the housing market logged a positive contribution to GDP after nine consecutive negative quarters.
On the negative side of the ledger, corporate capital expenditures (capex) were essentially flat, weighed down by a decline in spending on equipment for the third time in the last four quarters. Net trade was a modest drag, as growth in imports outstripped solid export volumes.
Strong private domestic final sales This metric gauges the economy’s underlying fundamental strength because it excludes volatile inventory liquidation or restocking, net trade, and government spending. It rose a strong 3.3% in the third quarter, nearly double the 1.7% gain in the second. While we do not believe the third quarter’s outsized strength is sustainable, we think GDP growth will decelerate over the next three quarters to a soft landing rather than an outright recession.
Inflation remains firm The core Personal Consumption Expenditure (PCE) index (the Federal Reserve’s preferred measure of inflation) slipped to an in-line 3.7% y/y rate of growth in September 2023, down from 3.8% in August and from its February 2022 peak at 5.4%, a 39-year high. In its latest Summary of Economic Projections in September, the Fed projected that persistent core PCE will fall to its long-run target of 2% by the end of 2026. But the core rose by 0.3% on a month-over-month (m/m) basis in September, matching this metric’s highest reading since May. In addition, the median expected inflation component of the final University of Michigan Consumer Sentiment Index for October soared to 4.2% versus 3.2% in September (the highest reading since May), largely due to the sharp increase in energy prices.
Wait-and-see approach for the Fed Apart from the blowout GDP report, the labor market remains strong. Initial weekly jobless for the October survey week fell to a 9-month low of 200,000, which suggests the labor market remains healthy and tight. If people have jobs, they’re likely to continue spending.
Given sticky core inflation, we think policymakers will remain patient, keeping interest rates higher for longer. While they may skip raising rates at next week’s Nov. 1 FOMC meeting, we expect they will maintain their optionality for an “insurance hike” in December or January, if the data warrants it. To be sure, the surge in benchmark 10-year Treasury yields from 3.25% last April to a 16-year high of 5% this week may, in fact, preclude the need for further hikes.
Details of the third-quarter GDP report:
Personal consumption (70% of GDP) rose by a very strong 4.0% q/q gain in the third quarter (accounting for 2.69 percentage points of the gain in overall GDP), in line with consensus expectations. But that compares with a much weaker second-quarter gain of only 0.8% q/q, so the recent third quarter growth was sequentially five times stronger. Spending was balanced, with services up 3.6% q/q and goods up 5.8%.
But we expect consumer spending to slow in coming quarters. The personal savings rate has declined from 5.3% in May 2023 to 3.4% in September 2023, so there’s much less dry powder. In addition, excess savings have plunged from a peak of $2.2 trillion in September 2021 to $530 billion in September 2023. Easter spending rose by only 1.7% in March and April 2023, versus 8.6% last year, and Back-to-School spending increased by 2.7% this year versus 9.8% last year. Likewise, we’re expecting a tepid Christmas in 2023, compared with 7.1% last year. Furthermore, we expect that robust “revenge travel” trends—which contribute to strong spending on services—will ease in coming months.
Inventories surged by $80.6 billion in the third quarter on a chained-dollar basis (adding 1.32 points), compared with a modest $14.9 billion inventory restocking in the second quarter. Auto-related companies were aggressively boosting inventories ahead of the UAW strike on September 15, so this nascent inventory build may unwind in coming quarters.
Government spending rose for the fifth consecutive quarter (after five consecutive negative quarters) by 4.6% in the third quarter (adding 0.79 points), compared with a 3.3% second-quarter gain. Federal spending soared by 6.2% in the third quarter (adding 39 basis points), versus a 1.1% increase in the second quarter. Defense spending drove this category, with 8.0% growth. State and local spending rose by 3.7% in the third quarter (adding 40 basis points), versus a stronger 4.7% second-quarter gain.
Residential construction rose by 3.9% in the third quarter (adding 15 basis points), marking the first positive contribution to GDP after nine consecutive quarters of declines. But mortgage rates more than doubled from 3% to 8% over the past two years, new and existing home prices spiked by 50% during 2021 and 2022 to record highs, and housing affordability has plummeted to its worst level since the mid-1980s. The housing market appears to be frozen at present, as most existing homeowners have no interest in giving up their current low mortgage rate, which suggests that this recent third-quarter reprieve could prove short-lived.
Corporate nonresidential capital spending was essentially unchanged in the third quarter (with no impact on GDP), versus a strong 7.4% increase in the second quarter. Structures rose for the fourth consecutive quarter, but only by 1.6% (adding 5 basis points), compared with a 16.1% second-quarter gain and a 30.3% increase in the first quarter. Equipment spending declined for the third time in the last four quarters, falling by 3.8% in the third quarter (subtracting 19 basis points), versus a 7.7% increase in the second quarter. Intellectual property spending grew by 2.6% for the eleventh consecutive quarter (adding 14 basis points), compared with a 2.7% second-quarter gain.
Net trade subtracted 8 basis points from overall GDP growth in the third quarter, compared with a modest 4 basis-point addition in the second quarter. Despite the relative third-quarter strength in the dollar against the yen, pound and euro (which make our exports more expensive), exports rose by 6.2% in the third quarter (adding 68 basis points), versus a decline of 9.3% in the second quarter. Imports rose by 5.7% in the third quarter (subtracting 75 basis points), compared with a 7.6% decline in the second quarter.