Slow and Steady GDP Gains Ahead

Third quarter GDP growth of 2% (annualized) is neither much to cheer about nor cause for alarm. The third quarter’s performance, an initial estimate that will be revised one month from now with fresh information on trade and inventories, is an improvement, albeit a small one over the second quarter’s growth rate of 1.7%. But it’s not enough to gladden the White House or dissuade the Federal Reserve from moving next week to loosen credit and dampen long-term interest rates.

An increase in consumer spending -- which accounts for more than two-thirds of economic activity -- reaffirms our expectation that when all is said and done, GDP will rack up growth of about 2.8% in 2010 and about 3% in 2011. After a rousing fourth quarter in 2009 (5% annualized growth) and a good first quarter of this year (3.7% annualized growth), recent sluggishness has been disappointing, raising fears that the economy will again tumble into recession. We think there’s enough momentum to avoid such a near-term decline, however.

Indeed, there are plenty of good reasons to expect improvement in the months ahead, including:

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• Rock-bottom interest rates.

• The giant pile of cash that businesses are sitting on, providing plenty of fuel for continued purchases of equipment, software and information technology. Spending on equipment and software increased 12% in the third quarter -- though well shy of the unsustainably torrid 24.8% sprint in the second quarter, that’s still solid. Businesses also boosted inventories last quarter by $115.5 billion, contributing 1.44 percentage points to overall growth. Although that pace will taper off, it’s a sign that businesses, while cautious, aren’t playing ostrich, burying their heads in the sand.

• Banks with plenty of capital to lend, once the spigots are loosened.

• An improved pace of consumer spending as more jobs are created. The 2.6% consumer spending gain in the third quarter is the best showing since 2006, before the recession.

• A housing sector that, though it remains in the dumps, won’t subtract from growth as it had been doing.

• Exports benefiting from global growth.

Look for federal government spending gains to wane in coming months as the $787 billon economic stimulus program passed by Congress in early 2009 winds down. In the third quarter, stimulus spending helped boost the federal government’s contribution to GDP by 8.8%. Spending by state and local governments was flat, as the recession took its toll on their revenues.

Because GDP measures domestic output, imports subtract from the final number. In fact, although exports rose 5%, imports increased by 17.4%. The net result lowered GDP by two percentage points.

One other notable number is a gauge of inflation closely watched by the Federal Reserve, which slowed to an annual rate of 0.8%. That is below the Fed’s target of between 1% and 2%, and will support those officials who will push for credit easing action at next week’s Federal Open Market Committee meeting.