The Bureau of Economic Analysis (BEA) released the advance estimate of real GDP growth for the third quarter of 2012 last week. Real GDP grew at a seasonally adjusted annual rate of 2.0%, up from 1.3% in the second quarter. Key contributors to growth were personal consumption expenditures (PCE), federal government defense spending and residential fixed investment (RFI).
Growth in PCE accelerated from 1.5% last quarter to 2.0% in this quarter, while the annual growth rate in defense spending jumped to 13.0%. Growth in RFI accelerated to 14.4%, from 8.5% last quarter as homebuilding appears to be gaining momentum. RFI has shown strong growth over the last four quarters, and is currently 13.8% above the third quarter of last year, compared to 2.3% growth for GDP overall. Restraints on stronger growth included declining exports and nonresidential fixed investment.
But despite improvements in PCE and RFI, growth in overall GDP remains tepid. The 2.0% growth rate is insufficient to bring down the unemployment rate, and is more likely to lead to higher unemployment. Economists credit Arthur Okun for providing a simple, but powerful framework for understanding the relationship between the unemployment rate and GDP growth. Referred to as “Okun’s Law” it is more widely accepted as a rule of thumb. Since originally articulated in the early 1960s economists have explored a range of variations, but the basic idea is that rapid (slow) economic growth will be accompanied by a declining (rising) unemployment rate, and this basic relationship is supported by historical experience.
The chart below shows percentage growth in real GDP (in blue) on the left axis and the unemployment rate (in red) on the right axis, inverted. The gray shaded areas are economic recessions. It’s clear that when the GDP growth is above 2.5% the unemployment rate declines and when growth slips below 2.5% the unemployment rate rises.
Various specifications of Okun’s law have produced a range of numerical estimates, most of which gravitate toward the result that every percentage point of GDP growth above 2.5% lowers the unemployment rate by one half of one percentage point.
The decline in the unemployment rate since the end of the most recent recession has been relatively small and tentative based on the sluggish pattern of GDP growth. Lowering the unemployment rate to between 5% and 6%, a rate considered consistent with a healthy economy, will require a sustained period of higher GDP growth, the faster the growth, the faster the decline in the unemployment rate. The current growth rate of 2.0% is an improvement from last quarter, but still not fast enough.