We’re Not Out of the Woods Yet

The economy grew at an unexpected annualized rate of 3.9 percent in the third quarter of 2007, according to estimates released by the Bureau of Economic Analysis this morning. This is a significantly larger jump than most analysts had expected.

The good news is that the economy was able to grow at a relatively strong rate despite a large downturn in the housing sector. Still, observers should be concerned. Growth was aided by a very low inflation rate, which is unlikely to be repeated any time soon, unlike the structural weaknesses in imports, housing, and investment, which are likely to remain.

Consumer spending growth recovered slightly in the third quarter. It increased by 3.0 percent, up from 1.4 percent in the second quarter. The increase in total consumer spending explained 54.1 percent of growth in the third quarter. Much of this growth occurred in spending on services, most notably housing and health care.

This increase in consumer spending helped to offset a large decline in residential housing sales and renovations. Spending on new homes and renovations dropped by 20.1 percent in the third quarter—the largest decrease in a year, and the seventh quarterly decline in a row. Prices for residential investments such as new homes and renovations dropped by 0.8 percent—the second such drop in a row—which contributed to the overall decline. This is the first time since the first quarter of 1992 that prices in this part of the economy declined for two quarters in a row.

Investment spending by firms, however, increased again at a healthy rate. All business investment increased by an annualized 7.9 percent. This was carried forward by spending on structures such as mining shafts and hospitals, rather than by investments in equipment, such as computers. The single largest increase in business spending on structures came for mining exploration, shafts, and wells, which grew by 27.9 percent in the third quarter, down from a remarkable 48.6 percent in the second quarter.

More good news came from trade. Exports increased by 16.2 percent in the third quarter—the largest quarterly increase since the fourth quarter of 2003. At the same time, imports gained 5.2 percent, the largest growth rate since a year earlier. As a result, the trade deficit shrank marginally relative to gross domestic product as it fell to 5.1 percent in the third quarter from 5.2 percent in the second quarter.

Much of the good news in the third quarter resulted from lower price increases in the economy. Inflation took less of a bite out of the overall economic performance. Specifically, the GDP price deflator rose by 0.8 percent in the third quarter, down from 2.6 percent in the second quarter of 2007. This was the smallest increase in this price gauge since the second quarter of 1998.

The slow increase in the GDP price index was the result of prices actually falling in a number of important sectors. Prices for durable goods, such as cars, dropped by 1.8 percent—the tenth decline in a row. Also, prices for residential housing fell, as did prices for computers and other equipment. Price increases for nondurable consumer goods, such as food and textiles, and for consumer services, such as health care and housing, were relatively modest. To some degree, the modest price gains reflect the continuing weakness in the housing sector and thus may only give inflation-adjusted economic growth a temporary boost.

Where does this leave us? There are essentially two lessons from today’s third quarter economic growth figures. First, consumers have proven to be more resilient than many observers expected. This resilience comes at the cost of an extraordinarily low personal saving rate, which totaled 0.8 percent in the third quarter, up from 0.6 percent in the second quarter. Yet this increase in the personal saving rate came at a time when prices for most families’ most important asset, their home, appeared to have fallen. Once people begin to realize that their homes are worth less than they expected, they may save even more and consume less—the so-called wealth effect in reverse.

Second, exports are the silver lining on the horizon. Thanks to strong exports, the trade deficit has gradually declined. Still, as the third quarter showed once again, even a small import increase can deny the economy most of the benefits of faster export growth.

It is important that the modest third quarter import growth happened when petroleum imports fell for the second quarter in a row. Petroleum imports were 16.9 percent lower in the third quarter than in the second quarter, following lower oil prices. Oil prices, though, have risen since the third quarter. While prices per barrel hovered in the low $70s for much of July and August, they rose to about $80 in the third quarter and have exceeded $80 for almost all of October. If this trend continues, petroleum imports could increase again and imports overall could surge.

The third quarter economic growth figures offer two important lessons. First, the economy needs to find another sector to carry it forward, such as faster business investment spending or faster income growth, to compensate for the possibility that people will save more amid losses in housing values. Second, the sooner the economy can wean itself off petroleum imports, the better it will be able to take full advantage of strong export growth in the form of much lower trade deficits.

The new figures released today surely provide welcome good news, but we’re not out of the woods yet.