GDP will receive a reality check in the second quarter

Like many other economic forecasters, I was expecting to see weak gross domestic product growth in the first quarter (Q1) of 2019.

In the second estimate of Q1 GDP released Thursday, we see that real GDP growth has been revised slightly to a still-strong 3.1 percent, down from the initial estimate of 3.2 percent.

But there is a lot more to the story than just the strong headline number. That’s because there is no such single thing as GDP. You cannot walk anywhere and measure a bucket full of gross domestic product. GDP is an accounting tool. It represents the sum of several different streams in the economy.

In the U.S., the biggest stream is consumer spending, which accounts for about two-thirds of total GDP. Hence, the saying among forecasters of the U.S. economy, “As the consumer goes, so goes the overall economy.”

The next stream that flows into GDP is investment. Investment consists of three different tributaries: business investment excluding inventories, business inventories and investment in houses and home repair, which we call residential investment.

Next comes international trade. In GDP, exports are added to the GDP total, while imports are subtracted. This is why economists talk about net trade. Finally, government spending is added to GDP. Government spending is further divided into federal spending and state and local government spending.

Many people are surprised to learn that state and local government spending is the biggest part of this grouping, accounting for about two-thirds of all government spending.

The different streams that feed into total GDP can do different things. Often some parts of the economy are strong and other parts are weak. So it is very important to look at the different streams and see what they are telling us.

In the first quarter, we see that real consumer spending increased at a 1.3-percent annualized rate. This is relatively weak by recent standards. In the fourth quarter of 2018, we saw real consumer spending growing nearly twice as fast, at a 2.5-percent annualized rate.

Further, we can say that out of the 3.2-percent real GDP growth headline number, consumer spending contributed just 0.9 percent to that figure.

Business investment excluding inventories increased at a 2.3-percent annualized rate in Q1 and added just 0.3 percent to the headline growth rate. This is also weak by recent standards. In Q4 of 2018, business investment increased at a 5.4-percent annualized rate.

Residential investment actually declined in the first quarter, dropping at a 3.5-percent annualized rate. This was the fifth-consecutive quarterly decline in that category. Residential investment subtracted 0.1 percent from headline real GDP growth.

Inventories are a big positive for Q1 GDP, adding 0.6 percent to headline GDP growth. Net trade was also a big positive, adding a full percentage point to headline GDP growth.

Government spending increased at a strong 2.5-percent annual rate, boosted by a surge in state and local government spending, adding 0.4 percent to the headline GDP growth rate.

When we look at the components of GDP in Q1, the story gets much more complicated than the strong headline growth rate suggests. Consumer spending, business investment and residential investment were weak while inventories, trade and state and local government spending was strong.

Another way to state this is that the fundamental components of GDP were weak in Q1, while the more variable and unsustainable components were strong, and that is what gave us a strong headline number.

Inventories swelled through the second half of 2018 into the first quarter of 2019. This cannot go on forever. It will likely reverse soon. Net trade numbers have been distorted lately as importers and exporters try to time their shipments ahead of changes to trade tariffs.

With a strong dollar and weaker global demand, I expect trade to soon resume its usual position as a small drag on U.S. GDP. Finally, the surge in Q1 state and local government spending is simply unsustainable and will correct very soon.

I expect real GDP growth in the second quarter of 2019 to step down from the strong pace of the first quarter, to something closer to 2 percent, reflecting an economy that is still expanding but at a moderate overall pace.

Robert A. Dye is a senior vice president and the chief economist at Comerica Bank.