While economic growth was probably strong in the third quarter, it's not expected to last.
A rebound in consumer spending and solid business investment likely contributed to a 4.3% jump in gross domestic product in the third quarter, up from a 3.3% pace in the prior quarter. But economists say the data were influenced by some unsustainable factors and that part of the strength was "borrowed" from the fourth quarter.
"Third-quarter growth was unquestionably strong," said Ethan Harris, senior economist at Lehman Brothers. "However, early indications of activity in the fourth quarter seem less upbeat."
Indeed, consumer confidence hit a seven-month low in October and retail sales have fallen over the past two weeks, according to the International Council of Shopping Centers. Although recent employment indicators have been mixed, Conference Board economist Ken Goldstein said Thursday that the labor market "could even be losing momentum going into the final months of 2004."
Of course, capital spending could accelerate going forward as companies take advantage of tax breaks that are set to expire at the end of the year, but the main concern lies with the consumer, who accounts for two-thirds of GDP.
J.P. Morgan economist Bill Sharp said consumption probably rose at a 4.6% pace in the third quarter, up from 1.6% in the second, as automakers aggressively stepped up incentives. But Sharp said the increase isn't likely to be repeated and he expects consumer spending to rise less than 2% in the fourth quarter.
"Most of the strength is statistical in nature, relating to the July surge in motor vehicle sales and the effects stemming from the averaging of monthly data in the calculation of quarterly growth rates," he said, adding that the underlying trend in consumer spending is still weak.
San Francisco Fed President Janet Yellen seems to agree. In a speech last Thursday, she noted that economic growth should pick up to a 4% pace in the third quarter but stressed that job growth has been disappointing, oil prices remain high and fiscal stimulus is fading. "I wouldn't say that we're completely out of the woods just yet," she said.
Although the corporate sector was a source of strength last quarter, with spending up at a double-digit pace, according to some estimates, Yellen said business spending is "less strong than one might expect" given the low interest rate environment and record amounts of cash.
She also noted that the burgeoning trade deficit will continue to detract from growth going forward. In the third quarter, the trade gap is expected to subtract about 0.7% from GDP.
While inventory accumulation probably added to growth last quarter, Lehman's Harris said companies have been adding to their stockpiles at an unsustainable pace and that this could act as a further drag on fourth-quarter growth.
"Don't get lulled into a false sense of optimism from this Friday's third-quarter GDP data," said David Rosenberg, chief economist at Merrill Lynch.
Rosenberg said real GDP in the three months ended in September was influenced by a decline in the price deflator to a projected 1.6% from 3.2% in the second quarter.
"It was the near 4%
seasonally adjusted annual rate price deflator in the second quarter that cut into real growth that quarter," he said. "And it was the sharp deceleration back towards 2% that helped out the pickup in real spending activity in the third quarter."
Looking ahead, Rosenberg said the evidence points to a slowdown. He noted that the Conference Board's index of leading economic indicators has now fallen for four straight months. In the past, this has only happened seven times during an economic expansion and in the next two quarters real GDP averaged just 1.6% and 2.4%, respectively. "This means that an average of 2% growth through to March '05 would represent the norm," Rosenberg said.
Vincent Malanga, president of LaSalle Economics, said economic growth could range from 2.5% to 3.5% over the next three quarters, as high energy costs, tepid job gains and fading fiscal stimulus depress consumer spending. He also noted that household savings are very low while debt levels are high.
In recent years, consumer spending has been driven by disposable personal income, a drawdown of savings and increased borrowing. But economists note that the trend in consumer credit is heading lower and that the U.S. savings rate now sits at less than 1%.
"The reduction in saving to fund additional spending from this point forward seems improbable," said Lacy Hunt, chief economist at Hoisington Investment Management. "Disposable personal income, therefore, is the primary source of spending power going forward."
Unfortunately, this measure also points to slower growth ahead. The 12-month growth rate in real disposable income -- the portion of income that is left over after taxes and inflation -- has fallen to just 1.6% from 4.3% at the end of 2003, implying spending of around 1.5% over the next year, Hunt said.
While more tax cuts, a new round of refinancing, or an accelerated pace of job and/or wage growth could boost this source of spending, economists say rising interest rates and high energy prices are likely to act as headwinds over the near term.
In other words, the "soft patch" has yet to run its course.