April 29, 2004

Good GDP growth for the first quarter, but risks to growth emerge

The U.S. gross domestic product (GDP) grew at a brisk 4.2% pace in the first quarter of 2004.   That increase is fast enough to generate jobs with productivity growth near 3%, and about the average 4.1 % growth rate for all non-recession quarters since 1970.   The economy appears to have enough momentum to sustain growth at a modest rate through the rest of this year.   Key details in today’s numbers, however, are flashing warning signs that the economy may slow in coming quarters:

• a spike in inflation (which could lead to higher interest rates),
• investment grew at a 7.2% pace, half the pace of the previous two quarters,
• defense spending spurted at an unsustainable 15% rate, and
• cuts in state and local spending seem to be accelerating.

Although the growth rates in the last two quarters were virtually the same—4.1% versus 4.2%—the sources of growth differed significantly.   In the first quarter of 2004, consumers spent far more on food and clothing and much less on automobiles than in the previous quarter.   Investment contributed more than half of the growth in the fourth quarter of 2003, but only a quarter of the growth in the first quarter of 2004.  

Increased debt continued to fuel consumer spending.   Although personal income grew by $128.9 billion in the quarter, consumer spending rose even more: $134.9 billion (in nominal terms).   Higher spending was driven both by private borrowing and by the government borrowing needed to finance the $26.5 billion reduction in income taxes for the quarter.

The numbers suggest another wide gap between the income gains for labor and corporations.   Real wage and salary income inched up at a rate of only 1.5% to finally exceed the level of three years earlier.   Total labor compensation grew at a 2.9% rate.   Although official numbers on first quarter profits will not be available for another month, the wide gap in the growth rates of labor compensation and GDP (and the reports from individual corporations) suggests that profits again grew very strongly in the first quarter of 2004.   To generate a strong, self-reinforcing growth spiral, labor compensation must grow at a rate comparable to overall GDP.

Defense spending has been the fastest growing major sector of the economy, both in the last quarter (15.0%) and in the last year (13.5%).   Defense spending alone contributed $17.0 billion of the total $108.5 billion increase in first quarter GDP.

Cuts in state and local spending pulled down GDP growth by 0.33 points, triple the 0.1 percentage-point drag in the fourth quarter.  

Despite the dollar’s decline over the last two years, the net trade balance contributed negligibly to first quarter growth (0.02 points).   Exports grew at a 3.2% pace, down from a torrid 20.5% fourth quarter pace.   Likewise, imports slowed from a 16.4% pace to just a 2.0% pace in the first quarter.   Because imports are 46% larger than exports, trade creates a drag on growth unless exports grow 46% faster than imports.

Inflation provided the biggest surprise in today’s GDP numbers.   Inflation had reached such a low level in the last three quarters of 2003 that Federal Reserve officials were expressing concern about deflation.   In the first quarter of 2004, however, the inflation rate for GDP jumped to 2.5%, about a point higher than in the previous three quarters, and inflation for consumers soared to a 3.2% rate, two percentage points higher than the previous three quarters.  

As Federal Reserve Chairman Greenspan testified recently, inflation does not seem likely to maintain the recent pace.   Commodity prices (including oil) have risen sharply in the last year as the world economy has picked up speed.   As the costs of commodities work their way through the economy, inflation gets pushed up.   But the major driver of inflation in the economy is labor costs adjusted for inflation.   So-called “unit labor costs” have been negative in recent quarters.   Recent labor cost numbers have remained modest, and today’s numbers on GDP suggest that productivity has remained strong.

Today’s inflation numbers for the first quarter largely confirm the pattern of monthly inflation reports this year.   Those inflation numbers have already caused longer-term interest rates to rise significantly.   If higher long-term interest rates persist, the Federal Reserve may be compelled to raise short-term rates to prove its vigilance for inflation.   Higher interest rates would slow both business investment and consumer borrowing.

The combination of tax cuts and more defense spending have made fiscal policy highly stimulative in the last year, but the fiscal impulse will turn contractionary in the second half of 2004.    It would be unfortunate if, at the same time, the Federal Reserve raised interest rates.   An interest rate hike would risk choking off growth before the economy built up the necessary momentum to generate a large number of jobs and gains in labor compensation on a sustained basis.

—by EPI Research Director Lee Price

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