May 2007

Growth Slows in First Quarter 2007

Real GDP growth slowed to a 1.3 percent annual rate in first quarter 2007 from a 2.5 percent rate in fourth quarter 2006, according to the Bureau of Economic Analysis’s advance estimate. While the pace of economic activity certainly cooled in the first quarter, the 1.2 percentage point drop in the GDP growth rate probably overstates the extent of the underlying slowing. Unusual declines in exports and federal government defense outlays combined to subtract about 0.4 percentage point from first-quarter growth.

Chart 1 breaks out recent GDP growth into contributions from its broad components. Consumption continued to be the main driver of growth in the first quarter. The contribution from nonresidential fixed investment swung from negative in 2006:Q4 to positive in 2007:Q1, but remained somewhat weak compared with its recent average behavior. The change in business inventories continued in negative territory.

As was the case in 2006:Q4, residential investment continued to be the most significant drag on growth, subtracting a full percentage point from growth in the first quarter.

Chart 2 isolates the contributions from residential investment over the past few years and shows the extent to which residential investment, in recent quarters, has taken a bite out of real GDP growth. Having contributed nearly 0.5 percentage point to quarterly growth rates over 2002:Q1 to 2005:Q3, residential investment has since subtracted an average of 0.7 percentage point each quarter. Note, though, that the drag in 2007:Q1 was somewhat less than in the prior two quarters.

An Average Residential Downturn
In terms of duration and depth, the current downturn in residential investment would be roughly an average downturn for the post-World War II period, provided that it met one unlikely condition—that it ended tomorrow.

Chart 3 shows a scatter plot characterizing 13 prior residential investment downturns in terms of duration (points farther to the right are longer downturns) and depth (points lower on the plot represent deeper downturns, where depth is measured by the percentage decline in real residential investment from peak to trough). [1] The average of the 13 prior episodes is also indicated. The average downturn lasted 6.5 quarters and resulted in a peak-to-trough decline in real residential investment of about 20 percent. This is very close to what we’ve already seen so far in the current episode, also represented on the plot.

The two points with green markers—the episodes from 1994:Q3 to 1995:Q2 and 1964:Q2 to 1967:Q1—are the only prior residential investment downturns that don’t overlap with economywide recessions.

Business Investment Growth Remains Sluggish
As noted above, nonresidential fixed investment—business investment in structures, equipment and software—picked up slightly in 2007:Q1 after declining in 2006:Q4. At a 2 percent annual rate, however, growth was still quite weak by recent standards. In both 2005 and 2006, real nonresidential fixed investment grew by about 7 percent.

New orders for so-called core capital goods (nondefense capital goods excluding aircraft) did show a strong uptick in March, growing a relatively robust 4.8 percent after having declined in four of the five prior months. Nevertheless, orders are still down 4 percent on a quarter-to-quarter basis and 0.6 percent on a 12-month basis.

The trend in orders points to continued weakness for business fixed investment. Chart 4 plots the two-quarter annualized growth rates of real nonresidential fixed investment and new orders for core capitals goods, with the latter shifted forward one quarter.

Core Inflation Slows a Bit
The March data on Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE) inflation contained welcome signals that core consumer price inflation may be returning to the decelerating trajectory it had been on prior to January and February.

The indexes for CPI and PCE excluding food and energy both showed scant increases in March (0.7 percent and 0.6 percent, annualized). This follows two months with rates of increase at around 3 percent or better. Though slowing less dramatically, the trimmed mean PCE also showed a substantial deceleration in March, to a 2.1 percent annualized rate, from rates of 2.5 percent and 2.8 percent in the prior two months. Twelve-month inflation rates for CPI excluding food and energy, PCE excluding food and energy, and the trimmed mean PCE are shown in Chart 5.

One factor that has been working in favor of more moderate rates of core inflation is the behavior of Owners’ Equivalent Rent (OER). Over the past four months, OER in the CPI has grown at an average annualized rate of 3.2 percent, after occupying a range of 4–5 percent for much of 2006. The PCE equivalent to OER has decelerated similarly.

—Jim Dolmas

Note Identifying expansions and contractions in economic series always involves some judgment. While a simple rule like “two or more consecutive quarters of negative growth represent a downturn” has some appeal for its simplicity and objectivity, episodes that seem evident to the naked eye as downturns are often interrupted by a single “up” quarter. Hence, the rule I used corresponds roughly to identifying cycles in a four-quarter moving average of real residential investment. This yields 13 downturns (not including the current one) in the real residential investment series since 1947.