If one takes a comprehensive look of the economy, substantial weaknesses are apparent. This is despite the fact that the Bureau of Economic Analysis released figures today showing the economy growing at a rate of 4.2 percent in the first quarter. A realistic assessment of the economy, though, has to look beyond the most recent quarter. Despite reasonable growth, the labor market is weak. Moreover, the main factors that have propelled growth forward – housing and investment – have slowed. And consumption, which was the major contributor to growth in the first quarter will likely slow without a robust labor market. This is not to denigrate current growth, but to keep a realistic outlook for future growth.
After growing at an average rate of 6.1 percent in the second half of 2003, the economy continued to expand at a respectable rate of 4.2 percent in the first quarter. This growth resulted in large part from strong consumption, which explained 63 percent of the growth rate in the first quarter. Also, business investment spending added fuel to the economy. Businesses spent 11.5 percent more on equipment in the first quarter, compared to the previous quarter.
Despite strong growth, the figures released today also show that there are substantial weaknesses. Most notably, the labor market is still waiting for a robust recovery. While the economy grew by an annual average of 5.5 percent in the past three quarters, inflation adjusted wages and salaries rose by 1.8 percent, or about three times slower.
Improvements in the labor market are urgently needed to maintain strong growth. Much of recent growth was due to consumption that was fuelled by mortgage refinancing. Consumer spending grew by 3.8 percent in the first quarter. Since income gains were slow, households fuelled consumption by cashing out their home equity. The refinancing boom, though, depended on increases in home values and lower interest rates. After a short surge in mortgage rates last summer, mortgage rates declined through March this year. However, in anticipation of an improving economy, mortgage rates increased recently. The effect of this increase will likely be felt in coming months, reducing refinancing activities and slowing the boom in housing and consumption activities. Following last summer's rate increase, the additional money that households had to spend due to equity cash-outs dropped from $99 billion in the second quarter to $47 billion in the fourth quarter.
As the refinancing boom slows down, something else has to take its place, to propel growth forward. Already the increase in spending for new homes and renovations slowed to its smallest increase, 2.1 percent, in more than two years. Let's take a look first at whether other sectors of the economy could replace consumption as an engine for growth. There is the government, which grew by 2 percent in the first quarter, despite a surge in national defense spending in the first quarter of 15.1 percent. Since many state governments still find themselves in fiscal troubles, their contribution to economic growth has been negative. Spending by state and local governments decreased by 2.6 percent in the first quarter.
Then, there are exports, which grew at a comparatively slow rate of 3.2 percent. Slow growth in overseas markets and resurgence in the value of the dollar are likely going to hamper further export growth. Moreover, the rise in exports was also offset by increases in imports by 2 percent. Consequently, the trade deficit remained above 4.5 percent for the first quarter. This leaves business investment, which slowed substantially in the first quarter. After expanding by double digit rates in the second half of 2003, investment grew by only 7.2 percent in the first quarter, largely driven by more spending for equipment and software. In comparison, business spending on buildings and construction continued to decline, reflecting the ongoing weakness in the commercial construction sector. Businesses will continue to invest only if they see rising demand for their product. It is unclear where that would come from if consumption, export, and government spending growth are slowing. In other words, investment demand is unlikely to be self-sustaining.
While current growth is respectable, we should not lose sight of the big picture. The goal is to sustain strong growth. Already, important contributing factors to the economy, such as the housing boom and investment are losing some of their steam of the past few quarters. Durable strong growth is ultimately only possible if demand for U.S. products grows. However, to do that firms have to continue hiring new workers at the strong pace of March 2004 and also increase the wages of their workers. Without a shift to income driven demand, though, this boom is less likely to be sustained.
- Monthly Percent Change in 30-Year Fixed Rate Mortgage, 2001 to 2004
Mortgage rates saw a sharp increase in the summer of 2003, but declined thereafter. This downward trend ended in April 2004. Mortgage rates increased by 0.5 percentage points from the end of March to the end of April.
Source: Board of Governors, Federal Reserve System, Release H.15 Select Interest Rates, Washington, D.c=: Board of Governors, www.federalreserve.gov.
- Consumer Credit as a Share of Wage and Salary, 1959 to 2004
Because wage and salary increases have been slow, households continued to raise their debt levels. Since September 2003, consumer debt, excluding mortgages, has averaged close to 39% of wages and salaries.
Source: Bureau of Economic Analysis, National Income and Product Accounts, Washington, D.C.: BEA, and Board of Governors, Federal Reserve System, Release G.19 Consumer Credit, Washington, D.C.: Board of Governors, www.federalreserve.gov
Christian E. Weller is a senior economist at the Center for American Progress.