November 16, 2009

Optimism Remains Tempered

With the close of 2009 approaching, the overall national economic picture remains much the same as the previous month. Many major data releases over the past two weeks indicate that economic activity continues to pick up, but some indicators suggest that we still have some way to go in the journey toward stability.

Overall Growth Exceeds Expectations
Real GDP grew at a 3.5 percent annualized rate in the third quarter, a bit faster than expected for the advance estimate.  An increase in personal consumption expenditures (PCE) accounted for most of the growth (2.4 percentage points), yet positive contributions were partly offset by negative contributions from net exports and nonresidential fixed investment (Chart 1).

The large positive contribution from consumption expenditures probably overstates the health of consumer spending.  Real PCE grew at a 3.4 percent annualized rate in the third quarter, but about 40 percent of that growth was due to purchases of new motor vehicles, stimulated by the government’s cash-for-clunkers program.  How much growth was a result of the government program is hard to say, but excluding purchases of new vehicles, real PCE increased at a roughly 2 percent annualized rate in the third quarter—a pickup from the second quarter’s –1.2 percent, but a modest rate of growth nonetheless.

The increase from inventories does not come from growth in inventories, rather from a slower rate of decline. Compared with prerecession levels, business inventories remain high relative to sales—we can expect businesses to continue paring inventories for some time.

Housing Situation Inches Back
The positive contribution from residential investment—the first since third quarter 2005—is consistent with the improvement we’ve seen in monthly measures of residential construction, housing starts and permitting activity. The most recent data, for September, showed residential construction up 3.9 percent from August, and up 7.7 percent from its low in June.  Nonresidential construction, though, has slid of late—falling 0.4 percent in September, and 4.9 percent since April. The decline in nonresidential construction seen over the past few months would have been significantly worse if not for the contribution of public nonresidential construction (Chart 2).

Existing home sales jumped 9.4 percent in September and are up 11.4 percent from second to third quarter, one of the strongest improvements of the housing indicators. In contrast, sales of new single family homes fell 3.6 percent in September, yet remain up 10.5 percent from the second quarter.

Manufacturing and Industrial Production Up, While Nonmanufacturing Treads Water
The manufacturing sector is most definitely rebounding: October’s ISM reading of 55.7 marked a tick up from September’s 52.6. The consensus had been for improvement in the index, as ISM values in the neighborhood of 52.6 are comparable to those seen in the first few months after the end of the past two U.S. recessions. The service sector, on the other hand, is basically treading water according to the latest ISM nonmanufacturing survey. The composite index for October came in at 50.6, down slightly from September’s 50.9 and very close to the threshold value of 50 that demarcates expansion from contraction (Chart 3).

Industrial production has increased over the past four months, though only a slight 0.1 percent in October. The third quarter saw an annualized 5.2 percent increase, about half of which represents growth in the production of motor vehicles and parts. These gains have come from extremely depressed levels, however; industrial production for October remained 12.3 percent below its December 2007 peak. At its lowest (in June 2009), industrial production was 14.5 percent off its prior peak.

Shedding of Jobs Continues as Firms Increase Productivity
As was the case last month, the job market picture remains the main roadblock to economic optimism. October saw a decline in payrolls of 190,000 and a rise in the unemployment rate to 10.2 percent—the highest since 1983. In this same month, the U-6 measure for labor underutilization [1] rose to 17.5 percent. This percentage spread between traditional unemployment and effective unemployment, 7.3 percent, is the largest the gap has been since the U-6 measure was introduced in 1994 and is far above the pre-2008 average of 3.8 percent  (Chart 4). This suggests that unemployment will remain high for some time even as the rest of the economy recovers, as firms will find it easier to transition part-time workers to full time in lieu of new hiring.

Additionally, the annualized increase in nonfarm business productivity in the third quarter was 9.5 percent, the largest increase seen in six years. This suggests that firms are still anxious to realign their resources in lieu of new hiring, reinforcing the belief that hiring may not resume for some time.

Price Changes Still Controlled
Twelve-month headline inflation rates have bottomed out, suggesting that serious deflationary pressures are becoming less of a concern (Chart 5). Since December of 2008, headline CPI has grown at an annualized 2.6 percent rate, while headline PCE has grown at an annualized 2.2 percent; both remain well below their precrisis peaks.

Core inflation rates, in general, continue to decelerate. CPI excluding food and energy did tick up in September, though slightly, from 1.46 percent to 1.50 percent. Inflation rates without food and energy have been supported of late by unusually robust growth in core goods prices, while core services inflation has slowed steadily. The base on which the pickup in core goods prices stands, in turn, is quite narrow, owing much to items like new and used motor vehicles and tobacco. As a result, core inflation is likely to trend down into 2010.

Financial Markets Normalize Some
While financial conditions have, to a degree, become more normal, the volume of credit outstanding remains low. Key credit spreads are down substantially from their crisis peaks, though somewhat above their long-term averages: for example, the Baa-Aaa spread, with a long-term average of 90 basis points, has dropped to 112 from its December 2008 high of 337. Measures of the volume of credit extended to businesses, however, have continued to drift downward and are well below precrisis levels.

Credit volumes, of course, reflect both the supply and demand for credit—reduced volumes may reflect a weak demand for credit, as well as a constricted supply. The extent to which a tighter supply of credit is constraining investment is unclear, since, even as net fixed investment is low, the amount of cash nonfinancial corporations have on hand, relative to their capital spending or their sectoral output, is currently well above average.

In sum, financial markets—and the economy as a whole—seem to be on the path to precrisis stability. Some aspects, such as a still-faltering labor market, remain a threat to this improvement. As such, the horizon remains hazy and the future uncertain.

—Max Lichtenstein and Jessica Renier

Note U-6 Labor Underutilization is defined as total unemployed, plus all marginally attached workers, plus total employed part-time for economic reasons as a percentage of the sum of total employed and marginally attached workers. We refer to this as the effective rate of unemployment. About the Authors Lichtenstein is a research assistant and Renier is a research analyst in the Research Department at the Federal Reserve Bank of Dallas.