GDP: Hot, It's Not

Don't be fooled by the blazing growth figures for the third quarter. In fact, the economy's current health is far less brilliant.

By Jerome Idaszak, Associate Editor, The Kiplinger Letter

November 29, 2007

Third-quarter economic growth, revised up to 4.9%, is a blowout number. Big deal. Sure, the latest estimate for growth in gross domestic product (GDP) during the third quarter is a full percentage point higher than the previous estimate. But the current quarter is another story entirely, with the rate of expansion looking on course for a feeble pace of 1% or so. Why? Consumer spending is slowing, exports are growing a bit less briskly and unsold inventories of goods are piling up. All of that is sparking talk of a pending recession.

We look for the economy to remain sluggish through the first quarter of 2008. Farther out, the drag from housing's slump will diminish, allowing the economy to expand by 1.5% to 2% for the full year.

The economy's vital signs don't point to an imminent recession, if past slumps are used as a guide. Granted, housing is in the dumps and probably won't show any improvement for a while, but other signs aren't nearly as gloomy.

Most important, job growth persists. The robust net gain of 166,000 jobs in October, the latest month for which figures are available, may be revised a bit lower when the November figures come out Dec. 7. But we'll still be a long way from persistent employment declines. Right now, announcements of big layoffs at some large companies are getting headlines. Largely unnoticed, however, is that small companies -- the real foundation of the employment market -- remain in hiring mode. Indeed, the latter group has accounted for about two-thirds of total job growth in the past 12 months. The latest survey by the National Federation of Independent Business, an industry group for small firms, shows that they are more cautious but still plan to increase payrolls in all industry categories except financial services and agriculture.

Another bullish signal comes from growth in inflation-adjusted personal income, a closely watched barometer of consumers' staying power. It is still healthy -- up 4.6% over the past 12 months and 4.1% over the past three months. It would have to level off or decline slightly for a recession to be under way. Consumers are getting stung by the housing slump, high energy prices and tighter credit markets. But, as long as their incomes are secure, spenders won't shut down.

On the downside, factory output is struggling. Though services account for about 80% of the economy, swings in manufacturing tend to act as a weathervane for the direction of the overall economy. Industrial production was very weak in October, falling 0.5% from the previous month. But that was the first decline since May, so it by no means signals a trend in the making. What's more, over half of manufacturers surveyed continue to report rising production levels.

Growing inventories are also a troublesome sign in the context of a weakening economy. It means goods are starting to pile up on factory floors and retail shelves just as sales are slowing. So, in order to work down their inventories, companies will throttle back on production.

The biggest risk factor for the economy is on the credit side -- that is, the possibility of a freeze in commercial bank lending as a result of fallout from the mortgage mess. If that were to occur, even creditworthy companies and households would find borrowing difficult and more expensive. The result would be a cutback in hiring, a sustained drop in production and flattening of personal income and spending.

Moves by the Federal Reserve to cut interest rates and pump money into the banking system are likely to head off a lending crisis. In fact, based on recent comments from Fed officials, we expect the central bank to lower rates again in December, largely in response to credit market jitters. Fortunately for the Fed, inflation pressures don't seem to be at the danger point, despite high energy and food prices. Inflation gauges included in the GDP reports show continued moderate price gains last quarter compared with the second quarter.

For weekly updates on topics to improve your business decisionmaking, click here.