The Bureau of Economic Analysis today released its advance estimates for U.S. economic growth in the fourth quarter of 2006, giving us a first peek at how the economy performed at the end of last year and how economic growth patterns changed over the course of last year. Preliminary results in the fourth quarter suggest that the U.S. economy could be turning to a period of export-led economic growth.
But first, the broad numbers. According to today’s figures, the U.S. economy expanded at an annualized rate of 3.5 percent in the fourth quarter of 2006, up from 2.0 percent in the third quarter. Thus, the economy in 2006 was 3.4 percent larger than in 2005, reflecting a small uptick in the growth rate from the 3.2 percent posted in 2005.
A look behind these numbers, however, reveals an important transition in the economy in 2006, from consumer-driven to investment-driven to perhaps more export-driven growth. For most of the current business cycle, which started in the second quarter of 2001, the economy had been carried forward by consumer spending, which in turn was fuelled by a very strong residential housing market. In 2006, however, the housing boom came to a halt and consumer spending growth slowed for much of the year.
Yet business investment continued to grow unabated, until the fourth quarter of 2006. The data released today raises serious doubts about how well business investment can function as an engine of economic growth going forward. Instead, exports appear to emerge as a new force to reckon with. Exports increased by 10.0 percent in the fourth quarter, the largest increase for the year, while imports fell by 3.2 percent, the first such decline since the fourth quarter of 2001. For the year, exports grew at 8.9 percent, up from 6.8 percent in 2005.
At the same time, imports grew only 5.8 percent, the lowest annual increase since 2003. These numbers indicate that the U.S. economy appears to be gaining strength in overseas export markets—even when taking into account lower oil prices in the fourth quarter, which certainly helped to reduce imports and shrink the trade deficit.
Consumer spending grew at a more modest rate in 2006 than in 2005. Consumption growth equaled 4.4 percent in the fourth quarter, up from 2.8 percent in the third quarter. For 2006, consumer spending grew on average by 3.2 percent, down from 3.5 percent in 2005 and 3.9 percent in 2004.
Underlying consumers’ moderation was the continued decline in the residential housing market. Spending on new homes and home improvements dropped again by 19.2 percent, after declining by 18.7 percent in the third quarter. This was the largest decline in residential real estate spending since March 1991. It was also the fifth quarter in a row that spending on residential real estate fell, marking the longest decline in this sector since 1982. For the entire year of 2006, residential real estate spending declined by 4.2 percent, the largest annual decline in 15 years and a sharp reversal of the growth rates of 8.6 percent in 2005 and 9.9 percent in 2004.
For much of 2006, the focus was on business investment as the potential savior of economic growth, until it declined in the fourth quarter. Business investment, the spending of businesses on new structures, such as plants, hotels, and offices, and on equipment, such as computers, software, and machinery, declined in the fourth quarter by 0.4 percent, the first decline since the first quarter of 2003.
Still, annual investment growth of 7.4 percent for 2006 was higher than the 6.8 percent recorded for 2005 and the 5.9 percent for 2004. The business investment boom of the current business cycle was remarkable since it differs from previous business cycle booms. Surprisingly, this investment boom has not been carried forward by investments in equipment, but rather by investments in structures. Previously, when business investment spending expanded at least as fast relative to GDP—as it did from the third quarter of 2005 to the third of 2006, before investment slumped—equipment spending expanded on average each quarter by an annualized rate of 0.4 percentage points relative to GDP and spending on structures expanded by 0.3 percentage points.
This time around, equipment spending did not grow relative to GDP, while structures grew by 0.5 percentage points, or 58.8 percent faster than in the past. In other words, the strong investment growth rate that characterized much of 2006 was carried by commercial construction.
Commercial construction still continued to grow in the fourth quarter, albeit at a much slower rate with 2.8 percent in the fourth quarter than the 15.7 percent increase in the third quarter and 20.3 percent in the third quarter. For all of 2006, business spending on structures increased by 9.1 percent, the largest annual increase since 1984.
Today’s figures, though, may signal an end to the commercial construction boom as spending declined. Employment in non-residential construction also fell in four out of the last six months. Moreover, growth in business investment went along with larger imports of capital goods and industrial supplies, which indicates that it took longer than in the past for investment spending to translate into gains of domestic economic activity and domestic jobs.
In the past, a business investment expansion of at least the same strength relative to GDP as through the third quarter of 2006 was associated with an average ratio of capital goods imports relative to GDP of 1.3 percent. Before the slump in business investment in the fourth quarter of this year, capital goods imports totaled 3.2 percent in the third quarter of 2006. The ratio of industrial supplies imports to GDP previously averaged 1.6 percent, compared with 2.2 percent in the business growth period from the third quarter of 2005 to the third quarter of 2006. This generally reflects the greater economic integration of the U.S. with the world economy.
When investments declined in the fourth quarter of 2006, so did capital goods and industrial supply imports. In inflation-adjusted terms, industrial supplies imports declined by 5.1 percent, and capital goods imports dropped by 0.2 percent in the fourth quarter.
These declines helped to propel the U.S. trade deficit substantially lower. In the fourth quarter of 2006, the inflation-adjusted trade deficit fell to its lowest level since the third quarter of 2004. Relative to GDP, the trade deficit fell to 5.2 percent from 6.0 percent in the third quarter. In relative terms, the trade deficit thus reached its lowest level since the first quarter of 2004.
As a result, the decrease in the trade deficit explained almost half, 46.9 percent, of the growth rate in the fourth quarter of 2006. The shrinking trade deficit, though, was the result of faster export growth as well as declining imports in the fourth quarter of 2006. Questions remain about which engines of economic growth—consumer spending, business investment and expanding exports—will sustain the current growth cycle.
Specifically, it is unclear how much longer consumers can maintain healthy consumption growth in the face of a sharply lower residential housing market. For consumption growth to be sustainable, it needs to be carried forward by more income growth. For much of 2006, the expectation was that faster investment spending will ultimately translate into stronger job gains outside of construction and housing-related sectors. Today’s figures raise doubt about the sustainability of investment growth.
Yet it appears that exports may fill the void. Should this be the beginning of a longer trend, it would certainly be very welcome news. An export-led strengthening of the U.S. economy could help to boost growth and job creation in the U.S. while simultaneously contributing to a shrinking trade deficit. That would benefit employers and employees alike, especially if increased export growth led to higher wages for hourly and salaried workers in export-oriented industries.