Dallas Fed: Risk of Slower Growth Ahead

The Dallas Fed, like the rest of us, is having trouble figuring out where future growth in GDP is going to come from. What many people don't realize is how much of recent growth has been driven by inventory correction, and that this is coming to an end:

Risk of Slower Growth Ahead, by —Tyler Atkinson, Evan F. Koenig and Max Lichtenstein , National Economic Outlook, FRB Dallas: The U.S. economic recovery appears to have been solid through second quarter 2010. However, with fiscal stimulus measures and the inventory correction nearing an end, there are reasons to be concerned that growth will slow in the second half of the year. ...

An Unusual Recovery
The composition of growth so far in this recovery is a source of concern. During the recession, real GDP fell below final sales as firms sought to reduce bloated inventories. Once final sales began to recover, firms sought to moderate the pace of the inventory drawdown—they began to close the gap between production and sales. The recovery up to now, which began in third quarter 2009, has been unusual in how much it has relied on this production catch-up effect. Inventory investment has accounted for 57 percent of GDP growth in the first three quarters of the current recovery—the largest percentage in the past 60 years (Chart 2). In comparison, the fraction of GDP increase accounted for by residential investment during the first three quarters of the recovery, 2 percent, is a record low. This feeble contribution comes despite new home-purchase tax credits and Federal Reserve intervention in the market for mortgage-backed securities. Growth contributions from consumption and government purchases have been smaller than normal also, but well within the past range. Contributions from nonresidential fixed investment and net exports have been about average.

Unfortunately, it looks like this is coming to an end:

The Inventory Cycle Draws to a Close
It appears the inventory correction has nearly run its course. Output has now caught up with final demand for domestic product, signaling that the main boost to GDP growth from inventory investment is coming to an end (Chart 3). Unless producers or retailers now want to add to their inventories, in coming quarters GDP growth will be tied to growth in final demand. However, the inventory-to-sales ratio is at a level that in the past has meant little or no change in inventories relative to GDP (Chart 4). ...

If inventory correction is ending, what will take its place?:

Where Will Growth Come From?
Increasing government purchases were an important early source of growth in final demand during the recovery but have gradually faded. Support for residential investment from special tax incentives is at an end. Business investment has been growing well in recent quarters but usually acts as an amplifier of growth that originates elsewhere, rather than an independent source of strength. Real consumption spending is growing at roughly the same 3 percent pace as before the recession but starting from a lower base (Chart 5). To replace inventory investment’s contribution to the recovery, this growth rate would have to increase to 5.5 percent—a pickup that is uncertain, at best, given still-tight credit and households’ aversion to debt. Such an acceleration might even be undesirable because it would risk an exacerbation of global imbalances (large U.S. trade deficits and rising U.S. international indebtedness).

Net Exports a Possible Bright Spot
Net exports provided a big boost to U.S. final demand in second quarter 2009 with a 1.6 percentage point growth contribution. Since then, net exports have contributed little to growth, but there is some reason to believe that this will change in the second half of 2010. Through the first quarter, leading indexes for the U.S. and for the major industrialized countries as a group suggested that economic prospects here and abroad were improving about equally rapidly—a neutral for our net exports’ prospects. Meanwhile, the U.S. gross domestic purchases price index has been rising relative to the U.S. gross domestic product price index (Chart 6). A growing purchases/product price ratio means that U.S. imports are becoming more expensive relative to U.S. exports, encouraging growth in exports relative to imports. Ordinarily, this relative-price effect would kick in during the second half of 2010. However, recent developments in Europe have added to financial strains there and increased calls for fiscal restraint. So, while some increase in the growth contribution from net exports in the second half is possible, it is by no means certain.

Slower Growth Likely, on Balance
In sum, GDP growth will continue in the second half of the year but quite possibly at a slower rate than we’ve seen during the recovery to date. Deceleration is likely because the boost to growth from rising inventory investment is near an end now that output has caught up with final demand. The inventory boost has accounted for over 50 percent of GDP growth so far during the recovery, so a substantial pickup in final demand growth will be necessary to keep gains in employment and output from slowing. That the required pickup will occur is far from obvious.

So net exports is the big hope, but troubles in Europe cloud this forecast. However, even if the troubles in Europe end, or had not occurred at all, I'm not very confident that net exports can carry the load. But what else can?

Given this worrisome short-run outlook for GDP growth, and hence for employment, why do some people think cutting stimulus, which is what cuts to the deficit do, is the way to enhance the recovery?

Output can be written as Y = C + I + G + NX (output = consumption + investment + government spending + net exports). If we cut the deficit through reductions in spending and increases in taxes, we know G will go down (as spending falls) and that C and I will also fall (from tax increases on consumers and businesses). But somehow, the story goes, as GDP and employment are falling, confidence will go up so much that C, I, and perhaps NX will go up more than enough to compensate for the fall, and then some. However, if the confidence effect doesn't appear and generate very strong effects, and it's unlikely that it will despite the wishful thinking from some, deficit reduction makes things worse in the short-run, not better.