As 2013 begins, the issue of the moment is the next stage in the fiscal policy negotiations, especially the issue of raising the debt ceiling. But regardless of what happens with the fiscal cliff, the United States is already in a recession. The outcome of the remaining budget negotiations will determine whether it will be a mild recession or something more serious.
Let’s start this recession by looking at the composition of Q3 GDP (see table 1). It is the mix of growth in that quarter coupled with the consequences of the fiscal cliff that puts the US economy at risk for another recession.
Consumer spending grew 1.4 percent in Q3 and made up 0.99 percent of the 2.7 percent growth in Q3 GDP.
The October consumer spending data showed a 0.3 percent decline in real consumer spending. If the impact of Hurricane Sandy is anything like that of Katrina, there could be a similar decline in the November figures. That, in turn, will likely result in a decline in real consumer spending in Q4. The fiscal cliff negotiations could also have a negative impact on spending. Consumer confidence has already fallen sharply, as it did in the summer of 2011 during the last debt ceiling debate. With 70 percent of GDP coming from consumer spending, that raises the risk that Q4 GDP could be negative.
Real disposable incomes (incomes after taxes and adjusted for inflation) posted modest growth at the start of the year (see figure 1), largely due to falling energy prices due to mild weather. Since May, incomes are down slightly despite very modest employment growth (737,000 jobs, 0.55 percent). Since June, the savings rate has fallen 0.7 percent to 3.4 percent.
The number-one factor driving down income growth is a decline in real hourly wages. Real hourly wages for non-supervisory workers peaked in August 2010 at $8.95 in real 1982 inflation-adjusted dollars. Over the past two and half years, real wages have declined modestly, dropping by just over 3 percent (see figure 2). The beginning of the decline coincides with the initiation of the second round of quantitative easing by the Federal Reserve. During that time, gasoline prices rose by 36.2 percent, while food prices were up a more modest 7.1 percent.
The tax agreement signed at the start of the year will drag down income growth even further. The end of the Social Security tax holiday will cost $95 billion. That will shave another 0.8 percent of disposable income. The increased taxes on upper-income households will also remove some spending.
With no income growth, it’s going to be hard to sustain spending growth into the new year in the face of tax increases that will further reduce real disposable income.
There were significant downward revisions in the new home sales data published in October. The numbers show a flattening out of new home sales that began in February, with sales turning downward in May (see figure 3). With a pickup in building activity, there is a risk that inventories of new homes are greater than the demand, potentially resulting in a pullback in building next year. New home completions include homes built for rental purposes and owner-built units that are not included in new home sales, and as such, will always be greater than new home sales.
The weakness in home sales will undermine home construction going forward. What has been a modest positive for the economy will go back to being neutral or slightly negative.
Business investment fell in the third quarter. New orders for non-defense capital goods less aircraft orders, a proxy for future capital goods spending, rose 1.7 percent in October, but are still down 8.1 percent from a year ago and have declined in seven of the past 12 months (see figure 4). New orders for computers fell 9.3 percent in October and are down 25.7 percent from a year ago. Given the declines in new orders, business investment is going to remain negative for several quarters to come.
Business investment is being hurt by a decline in CEO confidence. As measured by Chief Executive magazine, CEO confidence fell 2.3 percent in November and has been down in five of the past six months.1 The magazine’s CEO confidence index fell from 5.11 in October to 4.99 in December. CEOs cited uncertainty over the fiscal cliff, tax policy, and regulatory change as the reasons for their growing pessimism. At the small-business level, future expectations of small business owners plummeted from +2 in October to -35 in November, according to a survey conducted by the National Federation of Independent Businesses (a rating above zero is a sign of optimism).2 The collapse in future expectations for small businesses was due to uncertainty over the fiscal cliff coupled with worries about escalating health care costs and a tsunami of new financial, health care, and energy regulations.
In an era of just-in-time inventory management, no increase in inventories in excess of sales is ever wanted or warranted. When it happens, it is quickly reversed. Non-farm inventories rose sharply in Q3, accounting for 1.16 percent of the 2.7 percent increase in GDP growth. In drawing down inventories in Q4, real GDP growth will give back some of the Q3 growth.
Global trade is slowing. The Baltic Dry Index, a proxy for global trade, peaked in late October at 1109 and fell to 826 in mid-December. The weakness in the Baltic Dry Index was reflected in the US trade data for October. US exports of goods and services fell 3.6 percent in October, the largest month-to-month decline since January 2009. The economic problems in both Europe and Japan are beginning to take a toll on US exporters. Imports were also down, although not by as much. The net result was a $2 billion month-to-month increase in the trade deficit. Unless reversed in November and December, which seems unlikely given the fall in the Baltic Dry Index, the decline in exports and the rise in the trade deficit will reduce Q4 growth.
Q4 GDP: The start of a recession
Putting these different developments together, one can roll up an estimate for Q4 GDP. What the confluence of factors add up to—Sandy, the fiscal cliff, the weakness in global trade, and the givebacks from one-time developments that boosted Q3 growth—is a negative forecast for Q4 GDP.
The projection for a negative fourth quarter uses the following assumptions:
- Consumer spending is flat on the quarter due to uncertainty over the fiscal cliff and the impact of Sandy.
- Business investment continues to decline as it did in Q3 due to fiscal cliff worries and weakness in European demand, taking -0.23 percent off of GDP.
- Half of the build-up in business inventories is reversed, taking -0.58 percent off of GDP.
- The pace of housing investment is halved by rising inventories and the impact of Sandy.
- Trade makes no contribution to GDP in the fourth quarter.
- Half of the surge in government spending is reversed, taking 0.36 percent off of GDP.
- State and local government spending continues to contract as it did in the third quarter.
The result: Q4 real GDP contracts by a little more than 1 percent.
Higher taxes and less government spending next year are likely. A recession seems likely, albeit the depth and duration of the recession will differ depending on the speed of the resolution.
- “CEO Evaluations of Current and Expected Future Business Conditions Even-Out at a Middle Mark.” Chief Executive.net. December 18, 2012. http://chiefexecutive.net/ceo-evaluations-of-current-and-expected-future-business-conditions-even-out-at-a-middle-mark
- “December Report: Small-Business Owner Confidence Plunges More than Five Points One of the lowest optimism readings in survey history” National Federation of Independent Business. Accessed January 4, 2013 http://www.nfib.com/research-foundation/surveys/small-business-economic-trends