GDP falls by -1.4%, but worry more about the future

Dan North | May 02, 2022

U.S. Gross Domestic Product (GDP) shrank at an annualized rate of -1.4% q/q as compared to already weak expectations of around +1%.

  • However, the negative headline is not the start of the recession which may happen in 2023-24 – the details of this report matter.
  • First, personal consumption expenditures, which account for 70% of all economic activity, grew at an annualized rate of 2.7% q/q, better than the 2.5% from last quarter and the 2.0% from the quarter before that. Overall investment, another critical component of the economy rose at a very strong 7.3% q/q rate.
  • But the report got killed mostly by net exports which took a massive -3.2% off the headline. In other words, excluding net exports, the rest of the economy actually grew +1.8% q/q. As the global economy struggles to get out of the Covid-19 pandemic, the U.S. is importing far more goods and services from the rest of the world, than the U.S. is exporting to the rest of the world. That net export gap grew by $192 billion (annualized) over Q4-21, and since GDP growth measures the change (growth) from quarter to quarter, one can see the colossal effect net exports had on the top line.
  • A contraction in inventories chopped another -0.8% off of the GDP headline.
  • A resulting measure of economic activity in the report, which excludes net exports and the change in inventories, is called Final Sales to Domestic Purchasers, and that grew at a decent annualized rate of 2.6% q/q.
  • Government spending took yet another -0.5% off of the top line, driven by a sharp -8.5% decline in defense spending.
  • The report also noted that the effects of Covid-19 continued to weigh on the economy but that it was difficult to measure. “In the first quarter, an increase in Covid-19 cases related to the Omicron variant resulted in continued restrictions and disruptions in the operations of establishments in some parts of the country. Government assistance payments in the form of forgivable loans to businesses, grants to state and local governments, and social benefits to households all decreased as provisions of several federal programs expired or were tapered off. The full economic effects of the Covid-19 pandemic cannot be quantified in the GDP estimate for the first quarter because the impacts are generally embedded in source data and cannot be separately identified.” 
  • Roaring inflation across the economy of 8.0% in the quarter, a 41-year high, also took its toll on the report. The actual dollar amount of GDP before inflation, also known as nominal GDP, actually grew 6.5% for the quarter. But after GDP inflation of 8.0%, real GDP grew at the aforementioned -1.4% (differences due to rounding). An illustration helps explain what’s happening here. Think of the economy as an ice cream store. In Q1, the dollar amount of sales (technically, value-added) for the store grew 6.5%, but most of that was due to inflation of 8.0%. After inflation, sales actually shrank by -1.4%. In other words, the number of ice cream cones sold actually fell by -1.4%, but since the price rose 8%, the dollar amount of sales rose 6.5%. If this pattern were to continue, it would be bad. Fewer cones would be sold, so there would be fewer employees needed to make, transport, and scoop them. And consumers wouldn’t be able to buy as many cones as they would like because the price would be too high compared to their income. That’s the double hit of inflation.

But all of that is in the past. The GDP report tells us what happened in January, February, and March – it’s backward-looking, and that’s why the stock market shook the report off and actually rose after its release.

What’s really concerning is what is likely to happen in the future, events which could well result in a recession in 2023-24. Inflation is out of control. To contain it, the Federal Reserve will have to raise the Federal Funds rate very sharply this year. And when the Fed is raising that interest rate to fend off inflation, it is deliberately trying to slow the economy, and it works, every time.

Financial markets are now anticipating that the Fed will have to raise the equivalent of ten 0.25% (25 basis points or bps) hikes this year, bringing the Fed Funds rate to around 2.75%. Since there are only six meetings left this year, that means the Fed will have to raise by 50 bps in at least two meetings, and May’s meeting will be one of them.

One sign that the Fed has raised too aggressively shows up in the inverted yield curve, where the Fed has raised short term rates so much, that it has driven them above long term rates. This condition has a virtually perfect record of preceding recessions by about 3-5 quarters. The first chart below is based on quarterly averages, showing that when the yield curve as represented by the blue line goes negative or inverts, it has always been followed by a recession. That did not happen in Q1.
wages - sept2021
But if we look at the yield curve daily, not quarterly, it did in fact invert for two days at the beginning of April. That is not a strong enough inversion to signal a recession – it has to be longer and deeper than that. But it’s uncomfortably close.
nfibsurvey - sept2021

Recessions usually occur because of a confluence of events. Another indicator that is just as good as the yield curve comes from the Conference Board’s Consumer Confidence survey. When survey participants hold a much more pessimistic view of the future than they do about the present, they are usually right. When those two measures sharply diverge, as shown by the blue line, it has always resulted in a recession over the past 50 years. And that measure is extremely low now.


job openings-sept2021
Spikes in oil prices, often caused by wars, have also been strongly associated with recessions in the past. We have one now. Some are arguing that because we have more of our own oil, and the economy is less dependent on oil than in the past, the current situation is not as meaningful as it once was. But the four most dangerous words in economic analysis are: “It’s different this time.”
job openings-sept2021

Finally, bursting asset bubbles are also associated with recessions. In the 2001 recession, it was the dot-com bubble that burst. In the 2007-09 recession it was the housing market bubble that burst. It’s entirely possible that we are in another housing market bubble now, as home price increases have far outstripped wage increases, and the recent sharp rise in mortgage rates is a further threat.


job openings-sept2021

In sum, the Q1 GDP report was certainly disappointing but it was caused by a record surge in net exports. More importantly, domestic consumption and investment held up, and we expect growth to continue in 2022. But consumer purchasing power is being destroyed by inflation, and the Fed’s quest to extinguish it will certainly put the economy at risk.

In addition, pessimistic consumers, an oil price spike caused in part by war, and a possible housing market bubble are further worrisome signs for 2023-24. A recession is not inevitable though. Another important yield curve between the 10-year note and the 3-month bill is showing no signs of inversion. The war could end anytime, taking pressure off of oil prices, and that could cause consumers to feel more optimistic about the future. Housing price growth could slow and wage growth could rise. And the Fed could engineer a “soft landing,” squelching inflation without sending the economy into recession. But after the mistakes this Fed has already made, I doubt it.

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