The American economy contracted for the second consecutive quarter April through June, at a pace of 0.9% due to weak inventory accumulation and an outsize decline in gross private investment, according to data released Thursday from the Bureau of Economic Analysis. However, the fact that the economy grew 1.1% in the second quarter when excluding inventories—which provided a 2% drag on overall growth—means the debate over whether the economy has descended into a recession will continue to rage in coming days. From our point of view, the economy will likely soon meet the formal definition of being in a recession, though it isn’t there yet. Whatever the case, the economy is ensnared in an inventory correction.
While the composition of growth during the first quarter of the year was dragged down by an inventory swing and weak external demand, the second quarter data reflected a noticeable deceleration of economic activity in the real economy—made up of middle market businesses that account for about 40% of the country’s GDP—due to weakening domestic demand and the combined impact of an energy shock, inflation, and rising rates.
Personal consumption increased by 1% in contrast with the 13.5% decline in gross private investment, which was driven by an 11.7% decline in outlays on structures and a 14% drop in residential investment. Although real final sales—our preferred metric of activity in the real economy—advanced by 1.1%, final sales to domestic purchasers declined by 0.3% in contrast with the 2% increase in the first quarter of the year. Thus, while the broader economy is likely not in a formal recession, economic activity in the real economy will remain on a knife’s edge in the near term. Firms, households and investors are likely to remain in a risk-averse crouch that is not conducive to growth anywhere near the long-term trend of 1.8% this year.
Recession and all that
The contraction of the U.S. economy during the second quarter of 2022 meets the conventional definition of a recession—that is, two consecutive quarters of negative growth. However, conditions do not yet meet the National Bureau of Economic Research’s formal definition, which takes into account a sustained decline in a wider range of economic factors such as employment, income, spending, industrial production, manufacturing and trade sales.
Whether the economy meets the conventional or formal definition of recession is in many respects immaterial. Either way, households and firms are reeling from combined energy, inflation, and rate shocks that have damped individuals’ purchasing power and are in the process of reducing household living standards. That is the toll levied by the inflation tax and is why it is critical to restore price stability to the economy as soon as is reasonably possible.
Down-market households and the big box retail stores that serve them or industrial ecosystems like housing are likely already contracting even if the broader economy continues to chug along at a decidedly sub-optimal level. Given the policy objective of price stability over at the Federal Reserve, rates will continue to rise into the middle of 2023. Thus, it will be some time before any substantial policy relief in terms of rate cuts or fiscal stimulus will be put in play.
While the economy contracted at a 0.9% pace on a seasonally adjusted annualized basis in the second quarter, it expanded at a 1.6% pace on a year-ago basis. Personal consumption expanded at a 1% pace which was driven by a 4.1% increase in demand for services in contrast with the 4.4% decline in outlays on goods. Spending on durables declined by 2.6% and outlays on non-durables declined by 5.5%.
Inside the debate over whether the economy meets the formal definition of a recession, one thing is certain given the stark contrast between the increase in outlays on goods and services: the economy is definitely in a “goods-cession.”
Gross private investment contracted by 13.5% while residential investment contracted at a 14% pace. And fixed investment dropped 3.9%. Non-residential investment slowed from a 10% increase in the first quarter to a 0.1% pace in the second. Outlays on structures dropped 11.7% and equipment spending fell 2.7%. The only real silver lining inside the dark cloud that was gross private investment was the 9.2% increase in intellectual property. Exports jumped by 18% which outpaced the gain in imports of 3%. Net exports added 1.43% to growth during the second quarter.
Government spending declined 1.9% during the second quarter, with federal spending dropping 1.9% and state and local outlays falling 1.2%. Overall government spending was a 0.5% drag on growth during the quarter.
The economy contracted for the second consecutive quarter which does meet the conventional definition of a recession even if the formal definition of a recession is not yet met. From our point of view that is immaterial given the energy, inflation and rate shocks currently cascading through the economy, which for many households and firms will feel like a recession.
Looking forward, consumer and household spending will likely pick up in the current quarter due to falling oil and energy prices as elevated gasoline costs abate. Net exports will likely continue to bolster overall economic activity; however, government spending and residential investment will continue to provide a drag on overall growth.