The first estimate of Q3 GDP growth is a dismal 1.6%, sharply lower than the 5.6% of Q1 and the 2.6% of Q2. In July - when I first predicted a US recession in 2007 - I forecasted that Q3 GDP growth would be 1.5% at the time when the market consensus was 3.1%. Given the onslaught of bad macro news in the fall professional forecasters started to cut their Q3 forecasts from 3.1% to 2.5%, down to 2.2% last week and 2% this morning. They were still wrong and overoptimistic as the actual first estimate came as 1.6%, only an epsilon higher than my July forecast of 1.5% (the same forecasters had gotten Q2 wrong too; my spring forecast for Q2 was 2.5% versus a consensus of 3.2%; the actual figure ended up being 2.6%).
The weakness in Q3 growth is widespread: real residential investment fell at an annualized rate of 17.4%, much worse than the 11.1% drop of Q2; the trade balance was a negative drag on growth as the trade deficit widened sharply in Q3 relative to Q2; inventory accumulation was slightly lower in Q3 than in Q2 thus being a small drag on growth as well; non durable consumption grew only at an annualized rate of 1.6%; and while durable consumption grew faster in Q3 than in Q2 you can expect significant slowdown in durable consumption in Q4 as the glut of autos and housing related durables consumption takes a hit on the economy. Even non-residential investment in structures that was growing at an annualized rate of 20.3% in Q2 slowed down its growth to 14% in Q3: you can expect a much sharper slowdown in such non-residential investment in Q4 and 2007 for reasons discussed below. Real investment in software and equipment – that had fallen in Q2 – recovered in Q3 to a 6.4% growth rate; but further weakness in the economy in Q4 and 2007 will lead to a significant slowdown in such investment in the quarters ahead.
What do these Q3 growth figures imply for Q4 and 2007 GDP growth? Expect today the usual spin with the soft-landing optimists – who were altogether wrong on Q2 growth and even more wrong on Q3 growth – having already started to spin the fairy tale of a Q4 rebound. This Q4 rebound has, so far, no base or data behind it: residential investment will be falling at a faster rate in Q4 than in Q3 given recent data on building permits and housing starts; non-residential investment that was, until now, growing very fast will sharply decelerate in Q4 and much more in 2007: see the lead story in the WSJ today referring to a McGraw Hill Construction study forecasting a rapid fall in construction spending in 2007 (including non residential construction and specifically stores and shopping centers), the first decline of construction spending since 1991. This weakness in residential and non-residential construction will directly affect retail activity where employment has already started to fall. Expect in Q4 and 2007 actual fall in durable consumption (autos, housing related consumption such as furniture and home appliances and other big ticket items) as the housing slowdown, the fall in home prices and the negative wealth effects of falling prices and reset of ARMs take a toll on consumption, especially housing-related durable one. Given the ongoing sharp slowdown in the economy, real investment in software and equipment will be growing less in Q4 and 2007 than in Q3. And both inventories and trade are likely to remain a drag on growth in Q4 as inventory adjustment will continue (with demand growing less than production) while a strong dollar will further widen the trade deficit in spite of the economic slowdown. The first leading indicators of economic activity for October – the Philly, Richmond and Chicago Fed reports – are all consistent with a further economic slowdown in Q4 relative to Q3. I thus keep my forecast that Q4 growth will be between 0% and 1% and that the economy will enter into an outright recession by Q1 of 2007 or, at the latest, Q2.
Which inspires me to produce a picture comparing forecasted current-quarter GDP growth (the median of forecasts from the Philadelphia Fed's Survey of Professional Forecasters) in 2006 with actual:
My interpretation: by and large, forecasters produce estimates of GDP growth that hug the 3% line because 3% is about the historic average for growth in the US. For the first three quarters of 2005 forecasters did very well. Forecasters missed the slowdown in 2005:Q4, the growth spurt in 2006:Q1, and the slowdown in 2006:Q2 and 2006:Q3. The Fed, the IMF, and professional forecasters are all predicting moderate growth (near 3%) for the fourth quarter. Why should we believe those forecasts?
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