Improved economic fundamentals, as reflected in rising household wealth and a recovering housing market, have positioned the US economy on the verge of entering a period of accelerating growth. The spark igniting the acceleration will come as the slowly improving employment situation finally reaches a tipping point where it begins unleashing years of pent-up demand from people who have been prevented by economic circumstances from establishing separate living units. The combination of higher taxes—particularly the expiration of the temporary payroll tax reduction—and the fiscal austerity measures known as “sequestration” will definitely dampen the rate of acceleration, but will not be sufficient to actually stop it.
If things are going so well, what happened in Q4 2012?
Before moving to the outlook, an explanation of what happened during the final quarter of 2012 is needed. Although revisions moved Q4 2012 real GDP growth into positive territory, a reading of 0.4 percent would generally have observers worried that the United States was at risk of falling back into recession, notwithstanding the relatively solid growth seen earlier in the year. However, the strength of important subcomponents in Q4 2012 and the recognition that growth in Q3 2012 was artificially inflated by factors that were sure to be reversed kept concerns in check.
Figure 1 shows a breakdown of the contribution of the various components of GDP growth in Q3 and Q4 2012. Although the 3.1 percent top-line GDP growth in Q3 2012 was much higher than the growth in Q4, the underlying fundamentals were stronger in Q4. Specifically:
- Over half of the growth in Q3 was attributable to increases in the rate of inventory accumulation and government spending (primarily federal defense spending). Rising inventories take away from future production, and the bump-up in defense spending was not sustainable given the current budget environment.
- In Q4, the economy more than gave back the inventory accumulation and the rise in government spending. These two declines shaved almost 3.0 percentage points off Q4 GDP growth.
- Particularly problematic in Q3 was the very slow growth in fixed business investment, which was a drag on GDP growth. Business investment rebounded strongly in Q4, contributing 1.3 percentage points to GDP growth.
- Personal consumption expenditures grew slightly faster in Q4 than in Q3.
- The weakness of trade in Q4 at first looks a bit worrisome, but the decline in real exports reflects weakness in demand from US trading partners rather than falling US competitiveness. The decrease in real imports, which adds to GDP growth, is a result of declining oil imports rather than an indication of a future slowdown in the US economy.
Figure 1. Contributions to percent change in real GDP
Figure 2. Changes in nonfarm employment
Whatever the strengths and weaknesses of the composition of growth in 2012, it was clearly not sufficient to ignite strong employment growth. As shown in figure 2, employment growth over the course of both 2011 and 2012 was slow—averaging 175,000 jobs per month in 2011 and 183,000 per month in 2012. Total employment still remains well below its pre-recession peak. As a result of the slow growth in employment, the unemployment rate is coming down very slowly (figure 3), and 12 million people are continuing to look for work three and a half years after the end of the recession.
Figure 3. Unemployment rate
The case for accelerating growth
One of the most significant improvements to the economic fundamentals in the United States has been the recovery in household net worth. Not only was current income impacted by the recession’s sharp uptick in unemployment, but assets of households also took a major hit as home values plummeted, leaving many homeowners with mortgage liabilities far above the value of their homes. After reaching a peak in Q3 2007, it took just a year and a half for household wealth to drop by almost one-quarter.
Figure 4. Household net worth
Now, as shown in figure 4, household wealth has almost returned to its pre-recession peak on a nominal basis. Significantly, the most recent increase in Q4 2012 coincided with debt levels rising for the first time since the recession, a sign of improving consumer confidence.
As household wealth continues to expand and rising employment contributes income, one of the factors holding growth in check—the lagging rate of growth of household formation—should begin to reverse. The recession and the weak recovery have had a profound impact on social dynamics in this country, as poor economic conditions have caused the rate of new household formation to slow dramatically. Households form when a person or group moves into a separate living unit. During the recession and its aftermath, this process slowed considerably. Rising unemployment and foreclosures took their toll, and people who would have otherwise formed an independent household were forced by economic necessity to move back in or remain with parents, other relatives, or friends.
Figure 5. Household formation and population
Figure 5 tracks the growth in population and household formation, setting both series to 100 in December 2004. In the period before the recession, the rate of increase in the population age 16 and above closely tracked the rate of increase in the number of households formed. With the onset of the recession in December 2007, net new household formation came to a near standstill. Although the rate of household formation has recently started to increase, the United States currently has 1.1 million fewer households than it would have had if household formation had kept pace with population growth.
The strengthening of the housing market, visible in the rise in household wealth, declining “for sale” inventories, and rising home prices, are strong signals that the United States is close to working its way through the painful aftermath of the collapse of the housing bubble. The US economy is approaching the tipping point where even a slowly improving employment situation should be able to begin to unleash the pent-up demand represented by over 1 million additional potential households currently waiting in the wings. Not only will housing construction and construction employment be supported, but rising household formation should also kick off a virtuous cycle of rapidly increasing demand for home-related goods and services, which in turn should support additional employment and more new household formation. A household formation rate exceeding the rate of population growth is a formula for accelerating economic growth.
Figure 6. Residential units under construction
Looking toward the construction sector, we are now seeing a sign that the resurgence is indeed underway: Housing is finally turning the corner. The uptick shown in figure 6 for the number of housing units currently under construction correlates well with the contribution of residential investment to GDP. After being a drag on growth for several years, residential investment reversed its trend and began to contribute to GDP growth in mid-2011, and it was a small net positive for 2012.
Political risk—muted temporarily
Recent actions by Congress and the White House in the name of deficit reduction will definitely result in slower growth than would otherwise have existed in 2013. However, because the actions are being implemented only in part and on a piecemeal basis, they are more likely to slow the rate of acceleration rather than stopping it or causing an actual contraction. The original fiscal cliff date of January 1, 2013, represented the combination of the expiration of a series of temporary tax provisions—including the Alternative Minimum Tax limits, the Bush tax cuts, and the 2 percent point decrease in the payroll tax—with the automatic spending cuts provided for by the Budget Control Act of 2011 (the sequester). To complicate things further, January 1 was also around when the Treasury would need an increase in the debt ceiling in order to pay bills already incurred. There is little doubt that if all the January 1 revenue increases and spending cuts had been allowed to take effect at once, the United States would currently be in or near recession-level performance. If a default had occurred due to an unwillingness to raise the debt ceiling, recession would have been guaranteed.
The fiscal cliff deal muted the economic impact of these measures by allowing only a portion of the expiration of the temporary tax reductions to stand—the payroll tax rose two percentage points to its former level, and taxes on the highest wage earners were allowed to return to pre-Bush tax cut levels—and delaying the sequester until March 1, 2013. The debt ceiling was also raised. Further, Congress averted a federal shutdown by agreeing to a spending plan before the March 27 expiration of the existing Continuing Resolution, keeping spending at sequester levels. It remains to be seen what the final resolution of the budget battles will be, but from the actions taken to date, the damage to the economy appears limited.