“Sound and fury signifying nothing” is an apt description of the 2.6% (1.8% year-over-year) seasonally adjusted annualized rate of growth in the third quarter of 2022. Excluding trade and inventories, real final sales to domestic private purchasers increased at an anemic 0.1%, according to government data released Thursday. That underscores our estimate of an elevated 65% probability of a recession over the next 12 months.
American firms ensconced in the real economy should, if they have not already, begin planning by increasing efficiencies, controlling costs and zealously protecting their labor force as the economy approaches the end of the business cycle.
In isolation, this above-trend growth pace reflects an underlying resilience of the domestic American economy and settles the question over whether the economy fell into recession during the first half of the year (it did not, nor is it in recession now) as opposed to providing a solid forward look at economic prospects. Despite elevated and persistent inflation, personal consumption increased at a 1.45 SAAR pace following a 2% expansion during the previous quarter.
Outlook for 2023
However, once one looks past the top line growth estimate and digs deeper into the data one can observe the conditions for an overall economic downturn in the first half of 2023.
The noise associated with volatile trade and inventory data that understated activity in the real economy during the first half of the year reversed course in the third quarter, creating the conditions for better top line growth that grossly overstates overall economy activity. Trade, which acted as a large deadweight on growth during the first quarter of the year, contributed 2.77% to GDP during the quarter. Given the soaring value of the U.S. dollar, this will be a one-time event and act as a large drag on growth in coming quarters.
During the first half of the year, we made the case that the better indicator of the true underlying pace of economic activity inside the GDP accounting identity are real final sales of private domestic purchasers, which exclude those volatile trade and inventory swings. That metric increased 0.1%, which is well below the topline estimate. Final sales by domestic purchasers increased 0.5% while overall real final sales advanced 3.3%; gross domestic purchases declined by 0.2%.
The policy takeaway is that a resilient domestic economy is absorbing an inflation and rate shock in a much better manner than is commonly acknowledged, and the path of monetary policy will remain anchored around restoring price stability.
We anticipate upcoming data on core inflation and the employment cost index will require the Federal Reserve to follow through on its commitment to restoring price stability via a higher policy rate, sustained reduction in its balance sheet and an overall policy tilt that requires tighter financial conditions—all of which act as a deadweight on growth, thus creating the conditions for what we estimate is a 65% probability of a recession over the next 12 months.
Therefore, we expect a 75-basis-point hike in the federal funds rate at the November FOMC meeting, a 50-basis-point hike in December and a peak policy rate above 5% by the end of the first quarter of 2023.
The data
Outlays on goods declined by 1.2% while spending on durables contracted 0.8% and purchases of non-durables fell at a 1.4% rate. This strongly implies a coming discounting of inventory by retail firms and a very rough traditional holiday season ahead.
The shift from outlays to durables continued during the third quarter as spending on services expanded at a robust 2.8% pace. Overall personal spending contributed just under 1% of overall GDP.
One of the major economic risks going forward is that uncertainty around the direction of inflation and policy is creating the conditions for an outsize decline in fixed business investment, and we can observe that inside the data. Gross private investment declined by 8.5%, fixed investment dropped by 4.9% which was driven by a 15.3% decline in outlays on structures; meanwhile, residential investment declined by a whopping 26.4%. Overall gross private investment subtracted 1.59% from GDP during the third quarter of the year.
Away from the residential and commercial real estate industries, the investment outlook looks much better. Investment in productivity-enhancing capital expenditures saw a 10.8% increase in equipment and a 6.9% increase in intellectual property. From our point of view this is critical given the elevated pace of inflation and weak productivity growth that has characterized 2022. We expect the difference between a short and shallow recession and a modestly more painful one will be the size of the decline in capital expenditures in 2023.
Exports increased by 14.4%, driven by a 17.2% increase in sales of goods and an 8.3% advance in services. Imports of foreign goods declined by 6.9%, purchases of foreign goods dropped 8.7% and imports of services increased by 2.3%.
Overall government consumption advanced 2.4% mostly on the back of a 4.7% increase in defense spending. Non-defense spending increased 2.3%, while state and local spending increased 1.7%.
The takeaway
Overall economic activity during the third quarter of 2022 accelerated at a 2.6% pace, driven by a one-time increase in trade, modest household consumption and a solid increase in capital expenditures. However, once one looks at the pace of economic activity excluding trade, domestic economic activity continues to grow well below the 1.8% long-term trend rate and clearly is at risk of falling into recession in the near term. It is critical that policymakers and firm managers prepare for a slowdown in demand, as the lagged impact of rising interest rates and inflation begins to exert a powerful downward pull on economic activity.
