Private Inventories Contribute to Q3 GDP Growth

The Bureau of Economic Analysis (BEA) reported that real gross domestic product (GDP) rose by 3.0 percent over the third quarter on a seasonally adjusted annual rate basis. However, residential fixed investment (RFI) fell by 6.0 percent over the quarter. Despite the decline in the RFI component, the contribution of gross private investment to GDP growth rose, reflecting a large increase in the contribution of private inventory changes. The contributions of personal consumption, exports, and non-residential fixed investment, while positive in the third quarter, were lower relative to their contributions to second quarter GDP growth.

Over the third quarter of 2017, personal consumption expenditures (PCE) represented the largest contributor to overall GDP growth. Contributions to growth account for both the change in the annualized growth rate over the quarter and the shift in the composition of GDP. The sum of the contributions to growth across the major accounting categories of GDP sums to GDP growth.

Although PCE accounted for the largest portion of GDP growth, its contribution was lower in the third quarter of 2017 relative to second. The lower contribution largely reflected a slowdown in PCE growth from 3.3 percent in the second quarter to 2.4 percent in the third. Similarly, the contribution of exports has also continued to fall reflecting a slowdown in growth from 7.3 percent in the first quarter to 2.3 percent in the third quarter. In the second quarter, export growth was 3.5 percent. However, the impact of imports on GDP growth has improved and in the third quarter of 2017, imports contributed positively to GDP growth because of the -0.8 percent decline recorded over the quarter.

The bigger improvement came from the contribution of gross private domestic investment. The contribution of private investment has improved for two consecutive quarters largely reflecting the increase in the contribution of the change in private inventories. In contrast, the other component of gross private domestic investment, fixed investment has recorded lower contributions to GDP growth. Growth of non-residential fixed investment has slowed over the past two quarters while RFI has declined.

The Great Recession was characterized not just by a decline in GDP, but also by a divergence of GDP from its potential level. Earlier analysis illustrated that the actual level of GDP has virtually returned to its potential level, the amount of production when the country’s resources are employed efficiently. For the first time since the fourth quarter of 2007, the growth rate of the economy in the third quarter of 2017 has taken actual GDP to slightly above its potential level.

In the aftermath of the recession, the output gap was closing as the federal funds rate ranged between 0 and .25 percent. The low rate contributed to both economic growth and to a rate of growth in actual GDP that exceeded the rate of growth of potential GDP. In the third quarter of 2017, the output gap turned positive as actual GDP now exceeds its potential level. As illustrated by the figure above, typically, when the output gap is closing because actual GDP is increasing to its potential and when the output gap is positive or widens because actual GDP exceeds its potential level, then the federal funds rate is increasing. This is captured by the + [.5 * (YActual – YPotential)] portion of the Taylor rule:

ἰ = ∏ + r* + [.5 * (∏ – 2%)] + [.5 * (YActual – YPotential)] + v

The + [.5 * (YActual – YPotential)] means that the federal funds rate, ἰ, should rise, all else remaining the same, as actual GDP returns to its potential level. At the same time, this portion of the formula also indicates that the federal funds rate should rise if actual GDP exceeds its potential. However, the federal funds rate has risen only modestly as the output gap has shrunk. Although this may have been because the federal funds rate may not have fallen far enough in response to the divergence of the output gap during the Great Recession. Presently, the federal funds rate is at a historically low level given that actual GDP now exceeds its potential level. The mid-1950s was the last time the federal funds rate was below 1.5 percent when the output gap was positive.



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