THE U.S. ECONOMY CONTINUED to slow last quarter. The advance Gross Domestic Product (GDP) report for the third quarter of 2006 estimated 1.6% annualized growth, as the rate of decline of residential investment picked up and the net export deficit widened considerably.
Outside of housing, consumer and business spending, and government purchases all gained momentum last quarter, and inventory accumulation also was surprisingly healthy. We expect some downward revision to inventory accumulation, as estimates of vehicle production are updated.
While some signs point to gradual stabilization of housing demand, for example steadying mortgage applications for purchase and improving home-builder sentiment, recent sharp declines in housing starts indicate that residential construction will continue to exert a substantial drag on economic growth in the months ahead.
However, recent decline in energy prices, strong growth in personal income and high equity values should support consumption, while momentum in capital spending appears solid and export prospects remain good as European growth continues to pick up.
These factors point to moderate but below-trend economic growth over the next several quarters.
Despite the recent below-trend economic growth pace, there has been little slowing in nonfarm-payroll gains, and the unemployment rate has continued to gradually fall. Higher rates of compensation and growth in aggregate hours worked are supporting solid income gains, but productivity growth has slowed of late, and unit-labor costs are rising at rates not seen since 1990. The resulting cost pressures are concerning to the Federal Reserve, and continued growth in labor inputs poses an economic risk amid the persistent output drag from residential construction.
Following the pickup in core inflation in the spring, there has been a modest deceleration in recent months. Further, sharply lower gasoline prices have now pushed year-over-year headline inflation below core inflation for the first time in almost four years, and market-based measures of inflation expectations remain restrained.
Still, core Consumer Price Index (CPI) inflation has run at 2.8% in the 12 months ending in October, while the 12-month rise in the core Personal Consumption Expenditures (PCE) deflator has reached 2.4%, near the top of the Fed's mid-year central tendency forecast for 2006.
Core consumer inflation that is elevated relative to the Fed's longer-run comfort range, along with unit-labor cost pressure, will keep the Fed on hold unless economic weakness persists and broadens. The increased likelihood that continued double-digit annualized declines in residential investment will constrain GDP growth to near 2% this quarter and in early 2007 has raised the chances of modest Fed easing next year.