US economy robbed Peter to pay Paul? Maybe not

NEW YORK: No sooner did the government report that third-quarter economic growth was the slowest in three years than the spinners went to work. The 1.6% increase in real gross domestic product is laying the groundwork for stronger growth in the current quarter and in ’07, some economists said.

Why? I know of no law of nature — or economics, for that matter — that says growth is a fixed pie, to be divvied up among quarters on a random basis. According to that logic, growth stolen from one quarter shows up in the one that follows. A strong quarter borrows growth from the subsequent one, which is destined to be weaker.

This is what we call the ‘Robbing Peter to Pay Paul’ School of Economic Analysis. Sure, there can be quarter-to-quarter “noise” in the economic data that has implications for the future. Unexpectedly strong demand may force companies to draw down inventories, subtracting from the current quarter’s gross domestic product growth and auguring increased production in the next. Or companies may introduce incentives (auto manufacturers’ zero-percent financing, for example) that shift the timing of consumer purchases from one quarter to another.

But in general, the trend in growth is driven by policy — fiscal and monetary. The slowdown that started in the second quarter of ’06, when real GDP grew 2.6%, and continued into the third is the result of the Federal Reserve’s efforts to normalise rates and bring growth into line with the economy’s hard-to-measure potential. The Fed started to raise rates in June ’04 from a rock-bottom 1%.

At 5.25%, the funds rate isn’t historically high in either nominal or real terms.

Just because rates aren’t high in an absolute sense doesn’t mean policy isn’t restrictive. The fact that the Fed has pushed the funds rate over the market-determined long-term rate and kept it there tells you that it is. Today’s economy may require a lower equilibrium rate — the rate that keeps it growing at its non-inflationary potential — than it did in the past.

So it shouldn’t come as a big surprise that growth is slowing from an average of 3.4% that prevailed from ’03 through ’05. That’s what’s supposed to happen. And without something to shock it out of its trend, slow growth is apt to continue.

With the polls favouring the Democrats to capture one or both houses of Congress, you can forget about tax cuts providing any incentives. On the monetary front, Fed officials have made it clear that inflation is a greater concern than any shortfall in growth. That doesn’t mean they’re right; it just means they don’t see the need to lower short-term rates just yet.

Those expecting an autonomous pickup in growth in the fourth quarter and beyond are challenging history, the Fed and the current statistics. In the long run, the only variable the central bank can affect is inflation, which it does by manipulating the overnight bank lending rate to adjust money supply. In the short run, however, changes in interest rates alter the incentives to spend and to save.

The Fed can’t do anything to affect domestic demand in India or China — government policies in those countries are responsible for that; its policies affect domestic demand in the US.

Almost all measures of domestic demand are slowing when viewed on a year-over-year basis to eliminate the quarterly noise. Final sales to domestic purchasers (GDP less inventories, with imports included and exports excluded) slowed to 2.4% in the third quarter, down two full percentage points from its cycle peak in the first quarter of ’04.

Real consumer spending slowed to 2.8% last quarter, year over year, from a high of 4.1% in the first quarter of ’04. Residential investment (housing) fell at a 7.7% pace in the third quarter from a year earlier, the biggest year-over- year decline in 15 years.

At its cycle peak in the second quarter of ’04, housing rose 13.7% year-over-year.

Business investment in equipment and software has rolled over as well, rising 5.7% in the year ended in the third quarter compared with a high of 9.8% in the second quarter of ’05. Only business investment in structures, which historically trails the business cycle, is growing at its fasted rate of the cycle (13.7%).

Away from the quarterly volatility, final domestic demand moves in large waves, not short jerky steps. The inflection points — its ebbs and flows — appear to be policy-driven; that is, they correspond to the Fed’s cycles of raising and lowering interest rates. Could this time be different?

It’s always a possibility the economy could experience some kind of spontaneous levitation in the fourth quarter absent tax or rate cuts. But I’m too much of a Doubting Thomas to believe in miracles.