Sunday, October 18, 2009

Inventory Restocking and Q3 GDP

by Bill McBride on 10/18/2009 02:43:00 PM

Professors Hamilton and Krugman have mentioned that Q3 GDP will probably be reasonably strong, see Hamilton's No L and Krugman's A smidgen of optimism. I agree.

But I don't think growth in Q3, or even in Q4, are the question. The key question is what happens in early 2010.

The following graph shows the contributions to GDP from changes in private inventories for several recessions. The blue shaded area is the last two quarters of each recession, and the light area is the first four quarters of each recovery.

Inventory Contribution to GDP Click on graph for larger image in new window.

The Red line is the median of the last 5 recessions - and indicates about a 2% contribution to GDP from changes in inventories, for each of the first two quarters coming out of a recession. But this boost is always transitory.

Following the 1969 recession, changes in inventory added 6.2% to GDP in the first quarter of recovery - and GDP increased at an 11.5% (SAAR) that quarter. No one is predicting a quarter like that. But a 1% to 2% contribution from changes in inventories is possible.

And Personal Consumption Expenditures (PCE) will be strong too.

The following graph shows real PCE through August (2005 dollars). Note that the y-axis doesn't start at zero to better show the change.

PCE The quarterly change in PCE is based on the change from the average in one quarter, compared to the average of the preceding quarter.

The colored rectangles show the quarters, and the blue bars are the real monthly PCE.

The July and August numbers suggest PCE will grow at about a 3.6% (annualized rate) in Q3, however retail sales suggest less growth in September (July and August were boosted by cash-for-clunkers). So maybe we will see 3% PCE growth in Q3, and that would mean a contribution to GDP of about 2%.

Add in positive contributions from net exports, an increase in residential investment (for the first time since Q4 2005), some increase in equipment and software investment - and Q3 should look pretty healthy. Yes, investment in non-residential structures will be ugly, but overall private investment will be positive (first time since Q3 2007).

However, I expect early 2010 to be a different story.

  • Changes in private inventories is transitory, and without a pickup in end demand, the boost will end soon.

  • Usually increases in Residential Investment (RI) lead the economy out of recession and provide a boost to employment. This time, with the huge overhang of vacant housing units, I expect any further growth in RI to be muted.

  • PCE also usually leads a recovery, however this time household balance sheets are still in need of repair - and I expect the personal saving rate to increase over the next year - leading to slow PCE growth.

  • Non-residential investment in structures will be a drag throughout 2010.

  • On the plus side, exports might continue to provide a boost (an export led recovery?)

    Although I expect solid GDP growth in Q3 (and probably OK in Q4), I think GDP growth in 2010 will be sluggish, with downside risks.