Comment on First Quarter Advance GDP Growth Estimates

The Bureau of Economic Analysis (BEA) released its advanced estimates for the economic growth rate for the first quarter of 2006. According to the BEA, gross domestic product (GDP) increased by 4.8 percent on an annualized basis in the first quarter, up from 1.7 percent. That is, following the weakest growth rate in almost three years, the economy put in its strongest performance in almost three years.

The single largest contributing factor to this strong growth rate was consumption. Personal consumption expenditures expanded at a robust rate of 5.5 percent in the first quarter — the fastest since the third quarter of 2003.

However, there are several factors that suggest that in the future other factors will have to step up to the plate. To finance this increase in consumption, households spent again more money than they earned. The personal savings rate was again negative with -0.5 percent of disposable income — income after taxes. In fact, this was the second lowest personal savings rate since the BEA kept quarterly data in 1947, with the lowest personal savings rate recorded in the third quarter of 2005. A negative savings rate indicates that families spent more money than they had in after-tax income, including employer contributions to pensions and health insurance.

The negative savings rate reflected a slowdown in disposable income growth. After adjusting for inflation, disposable income — income after taxes — increased by 3.7 percent. This was substantially lower than the increase of 6.5 percent in the fourth quarter.

What makes the decline in the personal savings rate also noteworthy is that while families have increased their consumption spending, they have reduced their expenditures on their homes. That is, the decline in personal savings comes at a time when the housing boom seems to be coming to an end. Household spending on new homes and renovations increased by 2.6 percent in the first quarter of 2006, even below the 2.8 percent of the fourth quarter of 2005, and a far cry from the close to 10 percent growth rate in the first half of 2005.

Without substantially stronger income growth in the future, household spending on consumption items and their homes will likely slow. After all, since the end of March 2006, gasoline prices and interest rates have soared, taking a bigger bite out of people’s wallets. Just since the end of March, gasoline prices have risen by 16.4 percent, according to the Department of Energy. And, mortgage interest rates have gone from 6.35 percent to 6.53 percent in the first three weeks of April, according to the Federal Reserve.

With obstacles growing to continued large increases in consumer spending, other factors will have to take over as drivers of economic growth. Specifically, this will require faster investment growth. Other increases are either offset by declines elsewhere or not sustainable. For instance, although exports grew by 12.1 percent, imports grew even faster with 13.0 percent, such that the trade deficit increased again. Also, defense spending increased 10.3 percent in the first quarter after declining by 8.9 percent in the fourth quarter, which is likely a reflection of procurements associated with the war in Iraq. And non-defense federal government spending grew again by 11.7 percent, just like in the fourth quarter of 2005, mirroring the reconstruction efforts after Hurricane Katrina. These increases in federal government spending alone contributed 15.4 percent to economic growth in the first quarter, but they are likely not sustainable in the face of large looming deficits.

In comparison, business investment growth may be more sustainable. Business investment jumped by 14.3 percent, the fastest expansion since the second quarter of 2000. This increase in business investment reflects a very strong surge in transportation equipment, up 39.6 percent in the first quarter, an acceleration in information technology and software spending, up 14.5 percent, and spending on commercial construction, up 8.6 percent.

The Energizer bunny of economic growth — consumers — may be running out of steam as income growth remains below spending increases and as price increases for energy and loans loom large. For healthier growth, the economy will need to see more and better paying jobs so that families can consume and save, thereby also providing businesses with the incentives to continue investing in plants and equipment.

Dr. Christian Weller is a Senior Economist at the Center for American Progress, where he specializes in Social Security and retirement income, macroeconomics, the Federal Reserve, and international finance.