The week's economic reports

Surprisingly strong reports on both third quarter economic growth and October employment highlighted the week's economic data. Stocks and bonds ended the week with the S&P 500 Index down 1.7 percent to 1,510, now up just 6.4 percent for the year, and the yield of the 10-year U.S. Treasury note fell 12 basis points to 4.29 percent.

Consumer Confidence: The Conference Board's consumer confidence index fell from 99.5 in September to 95.6 in October, the lowest reading since October 2005 following Hurricane Katrina. The percentage of respondents planning to buy major appliances posted its steepest decline in almost two years and the employment outlook softened dramatically. Those saying jobs are plentiful fell to 24.1 percent and those saying jobs are hard to get rose to 22.6 percent, the lowest and highest levels, respectively, in two years. The gap between the two narrowed to 1.5 points from a mid-summer high of over 11 points.

Gross Domestic Product: The advance estimate of real gross domestic product for the third quarter exceeded nearly all analysts predictions, indicating a seasonally adjusted annualized rate of growth at 3.9 percent following a 3.8 percent gain in the second quarter. On a year-over-year basis, GDP growth rose 2.6 percent following a 1.9 percent annual growth rate during the second quarter. This is the first of three estimates for the third quarter and will be followed by the preliminary estimate in late-November and the final estimate at year-end.

Despite the tumult in credit and housing markets, consumers continued to spend and personal consumption was once again the largest factor in overall growth contributing 2.11 percentage points of the 3.9 percent growth rate. Based on retail sales data, however, spending was concentrated in the month of July, prior to the many negative headlines that financial markets began to generate in August and September. Tighter credit conditions, declining home equity withdrawal, and plunging consumer confidence should lead to markedly lower personal spending in the fourth quarter, but remember that betting against the American consumer has been a losing bet for a very, very long time.

Other components that contributed to economic growth were net exports, government spending, and inventories that added 0.93, 0.73, and 0.36 percentage points to the headline figure, respectively. Fixed investment subtracted 0.23 percentage points, led by a 20 percent decline in residential expenditures after falling 12 percent in the second quarter. Housing continued to be a drag on the economy during the third quarter, but not nearly enough to offset the other rising categories.

The GDP price index, used to convert nominal growth into real growth, rose at an annualized rate of just 0.8 percent and was the subject of some debate since it was the lowest inflation adjustment in many years and comes at a time when energy prices are soaring. However, the 0.8 percent inflation rate is consistent with the consumer price index from the Labor Department over the same period and, though the price of crude oil began to rise in September, this preceded the sharp rise in gasoline and heating oil that began in October. During the third quarter, natural gas prices, an important element in home energy costs, were actually declining. This inflation adjustment should be much larger in the fourth quarter now that all energy prices are rising rapidly.

Due to higher inflation, a likely reduction in government spending, and weaker consumer spending, preliminary estimates for the fourth quarter are now as low as one percent. Higher exports during the third quarter were both a welcome sign and the intended consequence of a weaker dollar, but this too will be offset by higher prices for imported oil in the fourth quarter. As always, the big question going forward will be whether or not the American consumer continues to spend.

ISM Manufacturing Index: Like the Chicago Purchasing Managers' Index, the much broader Institute for Supply Management Index fell last month from 52.0 in September to 50.9 in October. Levels above and below 50 indicate expansion and contraction, respectively, and recent readings point unambiguously to a slowdown in the manufacturing sector, this index having declined for the last four months after peaking at over 55 during the summer.

Prices paid and new orders for exports improved while production fell and inventories rose. The employment component rose slightly but may deteriorate next month if inventories continue to grow - as in the GDP report, rising exports are the most important new development in this report. Manufacturing has clearly lost its momentum after the spring rebound and it is unlikely that any significant slowdown in domestic demand can be offset with higher exports. Recall that the ISM index fell below 50 two times at the beginning of the year - it now looks as though it is headed into that territory again.

Personal Income and Spending: Personal income rose 0.4 percent in September, equaling the gain in August, and now stands at +6.8 percent on a year-over-year basis. Personal spending slowed from a gain of 0.6 percent in August to an increase of 0.3 percent in September, likely influenced by tighter credit and plunging consumer confidence due to ongoing difficulties in financial and housing markets. The personal saving rate rose from 0.8 percent in August to 0.9 percent in September.

Labor Report: A total of 166,000 job were created in October and the unemployment rate held steady - see yesterday's post Stength in the service sector for details.

Summary: Positive reports on both economic growth and the labor market coming during a week when the Federal Reserve cut interest rates raises many, many questions about U.S. monetary policy and the current state of the economy. Add to this mix recent reports showing inflation to be benign and you have to wonder just what economic data compelled Ben Bernanke to cut short-term rates again last week. Real GDP at 3.9 percent, 166,000 new jobs, and inflation at 2.8 percent comprise a virtual economic nirvana - something that any central banker should be pleased with.

There are at least two important factors in play here - the timeliness and credibility of major economic reports. GDP figures reflect activity as far back as four months (sort of like looking in the rear view mirror while driving) and employment data is widely considered to be a lagging indicator (largely due to the reluctance of employers to dismiss employees until it is absolutely necessary). Both of these reports have some credibility problems (e.g., the GDP price index and the birth/death model), but the reporting of inflation leads by a wide margin in this respect. Fewer and fewer individuals believe the government when it comes to rising consumer prices - if last week's rate cut is any indication, it doesn't appear that the Federal Reserve believes them either.

A third factor, one that is probably more important than any economic report, is the growing realization that there are major problems with the financial system as a result of mortgage lending and structured investment products that, almost three months after the initial August shock, are getting worse and not better.

The Week Ahead: The week ahead will be relatively light on economic data highlighted by a report on international trade on Friday. Also scheduled for release are the ISM non-manufacturing index on Monday, productivity and consumer credit on Wednesday, and import/export prices and consumer sentiment on Friday.

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UPDATE 11/03/07 at 3PM PST:

In the comments, a reader asked about the GDP Price Index of 0.8 percent annualized during the third quarter - this figure is consistent with the CPI (which may not necessarily mean much) and when looking at the two over about the last four years, it does not appear to be completely out of left field.

The wild divergences in 2005 and 2006 seem to be more interesting than the third quarter of 2007 - maybe something worth looking into someday.

Part of the problem is that you don't hear much about the three month annualized rate of inflation - does anyone remember the CPI going negative in 2005 or to zero last year?