Up, down, and up again

Seven years into the recovery, the U.S. economy appears to be growing, but sluggishly. Recent figures for real gross domestic product (GDP) growth seem to show significant weakness. In the second quarter of 2016, real GDP advanced at a seasonally adjusted annual rate of just 1.2 percent, and first-quarter growth stood at a mere 0.8 percent. Moreover, real GDP growth in each of the last three quarters was slower than during any of the preceding quarters since Q1 of 2014.

Other data, however, contradict the gloomy picture of stagnation presented by the headline GDP numbers. The U.S. Bureau of Labor Statistics' monthly employment numbers, for example, tell a different story. Both the June and July reports were uniformly positive and strong, in terms of both the number of payroll jobs added to the economy and the increases in hours worked and wages earned. In addition, the labor-force participation rate grew during that period.

Article Figures

[Figure 1] Real stock of inventories Enlarge this image

A closer examination of the components of GDP growth helps to illuminate the reasons for this apparent disconnect. The bright spot of the second quarter was real consumer spending, which grew at an annual rate of 4.2 percent. Capital spending by businesses and residential investment fell, but the drop in residential investment is likely to reverse due to strong demand for housing. On the negative side, labor productivity has been a soft spot for the economy; nonfarm business productivity declined in every quarter between Q4 2015 and the second quarter of this year, making this the longest slump since the late 1970s. Productivity is an important factor in determining macroeconomic output, wages, and prices; the combination of higher wages and lower productivity is placing downward pressure on corporate profits, which are already under strain from the downturn in energy and commodity prices. Business investment has also been in negative territory for the past three quarters, while new orders for nondefense capital goods excluding aircraft has declined on a year-over-year basis for the past six quarters.

Not all is doom and gloom, however. Real final sales (real GDP less inventories) and final sales to domestic purchasers (real GDP less inventories and exports), which are better measures of the underlying strength of the economy than the headline number, advanced 2.4 percent and 2.1 percent, respectively, in the second quarter—a far cry from the 1.2 percent overall GDP growth seen during that period. This points to inventories as the main culprit behind the poor GDP performance. Indeed, the largest drag on GDP in the second quarter came from a US$8.1 billion drop in real inventories, the first contraction since 2011.

Such a decline portends good things for the economy in the third and fourth quarters, as businesses running on leaner inventories now will invest in building them up in the latter half of the year, thereby contributing to economic growth. Given that the June and July employment reports probably were unsustainably good, it's likely that greater inventory accumulation will resolve the disconnect between GDP and employment data, as the former catches up and the latter cools down.

The 2014-2015 inventory story
Slowing inventory investment has subtracted at least 0.3 percentage points from the annualized GDP growth rate in each of the last five quarters. This drag was the highest in the second quarter of 2016, hitting 1.2 points. An unintended inventory accumulation during mid-2015 is the cause; that excess had to be whittled down before another inventory build could begin. This accumulation was set in motion by a "perfect storm" of factors. These included the following:

• West Coast port labor disruptions. In 2014, a labor contract between a dockworkers union and an association representing their employers at U.S. West Coast ports expired. Tensions between the two groups mounted, and the dockworkers were accused of staging a labor slowdown in order to put pressure on the association to meet their demands. Both imports and exports were affected. On the import side, many ships were unable to unload their cargoes, leading manufacturers, wholesalers, and retailers to exhaust their existing inventories and struggle to restock. Many businesses began ordering supplies from other channels. When the labor dispute was resolved in late February 2015, the backlog of goods began flowing through the ports again. This led businesses to experience inventory surpluses, which peaked in the latter half of 2015.
• The strong U.S. dollar. The U.S. dollar's marked appreciation since late 2014 caught many exporters off-guard. Increased relative prices placed downward pressure on U.S. exports, which contributed to the accumulation of unsold inventories for exporting companies.
• The decline in global oil and commodity prices. World oil and commodity prices plunged in 2014 and 2015, reducing spending on equipment and structures like drilling rigs in the energy and mining industries.
• The global economic slowdown. Turbulence in world economies, and particularly China's financial turmoil and economic slowdown, dealt a blow to China's growth and to that of other emerging markets, reducing aggregate demand.
• The missing "pump-price dividend." When gasoline prices dropped in 2014, many retailers expected that the resulting savings would spur consumer spending in the third- and fourth-quarter shopping seasons. These businesses stocked up on inventory in anticipation of that demand. However, that demand did not materialize as expected. Instead, households used their "pump-price dividend"—which amounted on average to approximately $14 in savings per week in 2015 compared to 2014—to pay down debts, build up bank balances, and dine out.
• Warm weather. Unseasonably warm weather in the fourth quarter of 2015 resulted in poor clothing sales, as customers had little need of heavy winter gear. This led to a significant accumulation of inventories of clothing.

Economic and inventory outlook
When the current inventory drawdown is put into context, things no longer look so grim for the U.S. economy. Real GDP is projected to increase 1.6 percent this year, 2.4 percent in 2017, and 2.4 percent again in 2018. In 2017 and 2018, export and business-investment growth are expected to pick up due to a weaker dollar. Meanwhile, oil and commodities prices are likely to gradually increase during that period. Consumer spending will drive the expansion forward, supported by growth in employment, real incomes, and household net worth. However, auto sales are likely to start declining in 2018 after reaching an all-time high of 17.78 million units in 2017. Housing construction will continue to recover in response to pent-up demand from young adults and improved credit availability. In addition, the Federal Reserve will remain cautious in regard to raising interest rates.

Retailers are likely to lead the way in inventory building this year, but they will take it slowly because of tight margins, fierce competition, and price discounting. However, consumer spending remains one of the main drivers of economic growth, and retail inventory growth is expected to outpace that for manufacturing and wholesale inventory in 2016. (See Figure 1.) Manufacturing and wholesale inventories are expected to weaken in 2016, then grow at a significantly faster pace in 2017 and 2018 once exports perform better due to a weaker dollar.