Trade-related distortions in net exports wreaked havoc with gross domestic product data once again as economic growth increased by 3% in the second quarter, overstating the true underlying pace of economic activity.
Once one excludes the more volatile trade and inventory data, growth advanced at a much softer pace of 1.2% implied by final sales to private domestic purchasers, according to government data released on Wednesday.
Swings in net exports and inventory accumulation overstated weakness in the first quarter and strength in the second quarter.
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To put this in perspective, net exports contributed 4.99% to overall growth after proving a drag of 4.61% in the first quarter. A smoothed average of first-half growth implies a 1.2% pace of economic activity, which is in line with our 2025 forecast of 1.1%.
Alternative growth metrics support our forecast as final sales to domestic purchasers increased by 1.1% and gross domestic purchases declined by 1.9%.
The policy takeaway here is that the economy is growing well below the 1.8% long-term trend, which will lead to a policy change at the Federal Reserve once it gets a sense of where inflation stands.
In addition, with inflation in the second quarter advancing at a 2.1% annual pace—the July personal consumption expenditures index, to be released on Thursday, will most likely show a 2.6% increase—our baseline economic view of stagnation at best and stagflation at worst is coming into view.
The federal funds policy rate remains moderately restrictive, and we think normalization toward a terminal rate between 3% and 3.5% will begin in the near term. Based on our assessment of the second-quarter growth data, a September rate cut is in play even if our baseline monetary policy forecast remains a 25 basis-point reduction in December.
The data
Personal consumption increased at a 1.4% pace in the second quarter, just below our forecast of 1.5% as households increased outlays on goods by 2.2%, durables by 3.7%, nondurables 1.3% and services by 1.1%.
Trade-related distortions were evident inside the gross private investment category, which declined by 15.6% because of a slowing in outlays on equipment spending to a 4.8% pace, down from 23.7% in the first quarter. Investment in structures dropped by 10.3% while residential investment declined by 4.6%.
The brightest aspect of the GDP data was the 6.4% increase in outlays on productivity-enhancing intellectual property—think artificial intelligence—which advanced by 6.2% on average through the first half of the year.
Exports fell by 1.8% in the second quarter and imports declined by 30.3%. Exports of goods declined by 5% while services increased by 4.4%. Imports of goods declined by 35.3% and services by 5.4%.
Government consumption increased by 0.4%, mostly because of a 3% increase in state and local spending which offset the 3.7% drop in federal spending. Outlays on national defense increased by 2.2% and nondefense spending dropped by 11.2%.
Inventory accumulation declined by $26 billion in the quarter, following the $160.5 billion increase in the first quarter. The decline in inventories provided a 3.17% drag on inventories in the second quarter.
The takeaway
Trade-related growth distortions in both the first and second quarters make interpreting the GDP data challenging at best. Our estimate is that the economy has slowed closer to a 1% pace compared to an exaggerated 3% top-line number that was flattered by an increase in net exports.
The better gauge for underlying domestic growth implies a 1.2% pace of growth, which is in line with our 2025 forecast of 1.1%.
