Friday, July 28, 2006

GDP, Residential Investment and Savings

by Calculated Risk on 7/28/2006 10:46:00 AM

The BEA released the Advanced Q2 GDP report this morning.

From Dean Baker: Weakening Housing Market Slows Economy

GDP growth fell to 2.5 percent in the second quarter as consumption growth slowed and housing investment fell sharply. Equipment investment also declined for the first time since the first quarter of 2003. While the growth data is somewhat worse than expected, the report also provides evidence that inflationary pressures are increasing.

The weak consumption growth is directly related to the weakness in the housing market. Consumers have borrowed heavily against the growing equity in their homes over the last four years, as the savings rate declined from 2.9 percent in the first quarter of 2002 to -1.5 percent in the second quarter of 2006. This drop in savings translated into more than $400 billion in consumption growth over this period. Now that housing prices have stopped rising, and may even be falling in real terms, consumers are losing the ability to borrow further against their homes. This means that the savings rate is unlikely to slide still further into negative territory. As home prices weaken, the savings rate will begin to rise to more normal levels, and consumption growth will trail income growth. If job growth and real wage growth remain weak, then this implies that consumption will grow very slowly or even decline.
Here is residential investment as a percent of GDP:

Click on graph for larger image.

According to the BEA, the decline in Residential Investment dragged GDP down 0.4% in the 2nd quarter. Recent evidence suggests this "drag" will increase and will probably last for some time.

And the decline in Residential Investment is just the beginning of the impact of housing on GDP. In the second half of 2006, construction employment will probably start to fall, leading to a drag on employment growth and consumer spending.

And, as Dr. Baker noted, the savings rate has gone negative as homeowners have borrowed against their homes to maintain their lifestyle. As housing prices stabilize or decline, MEW (Mortgage Equity Withdrawal) will also decline. This will impact consumption expenditures.

UDPATE: Add graph of Core PCE inflation rate:

The Core PCE (Personal consumption expenditures excluding food and energy) increased at a 2.9% annual rate in Q2. Core PCE is rumored to be one of the FED's favorite inflation measures. This is the largest quarterly percentage increase in core PCE since 1994!

A slowing economy and rising inflation pressures - overall this is a negative report.