Bill Wood: Plenty of risk but also encouraging data for U.S. economic growth

From an economist's perspective, this has been a summer packed with surprises so far. Most of these surprises were unpleasant, and all of them could eventually have a substantial impact on the U.S. economy.

Unfortunately, there are reasons to believe that we have not seen the last of this trend. We still have a major election pending, an escalating crisis in the Middle East and half the hurricane season remaining with which to contend.

In the past few weeks, there has been an assassination attempt on former President Donald Trump, President Joe Biden exited the race, Crowdstrike triggered a massive IT failure and the Nasdaq melted down just a few days after posting an all-time high. There is also rising tension in the Middle East. I do not know how Iran's announced retaliation against Israel will turn out, but I am uneasy about this situation.

It will be several weeks before I know just how much, if at all, these particular events will affect the economy in the third quarter, but I am happy to report the Bureau of Economic Analysis released the advance estimate for U.S. gross domestic product in the second quarter. This produced yet another surprise for me—but this time my response was positive.

According to the BEA, the U.S. GDP increased at an annual rate of 2.8 percent in Q2 after adjusting for inflation. I was expecting a growth rate much closer to 1 percent. For an economic analyst, that is what you call a pleasant surprise.

The BEA will revise this number a couple of times in the coming months, so it is possible it will be tweaked lower. But barring a major revision, an inflation-adjusted rate of 2.8 percent is pretty close to the sweet spot for the U.S. economy—not too fast, not too slow. And to top it all off, the rate of overall inflation in this report was an acceptable 2.3 percent.

I suppose if we wanted to nitpick, we could say the perfect growth rate is somewhere in the range of 3-3.5 percent and the ideal rate of inflation is a steady 2 percent. But given all of the headwinds and uncertainty we are experiencing at this moment in time, I will happily take a 2.8 percent gain with a rate of inflation just a little over 2 percent.

Before I dig deeper into the numbers, I should offer an explanation as to why I was surprised by the growth rate from this report. Simply put, the GDP data was trending downward during the previous two quarters, and none of the leading indicators I track has gotten any better since that time.

The growth rate for U.S. GDP decelerated markedly in the fourth quarter of last year and then again in the first quarter of this year when compared with the previous quarters. I concluded that the restrictive interest rate environment imposed by the Fed was having its intended effect on overall demand, and until the Fed lowered its interest rate, economic growth would continue to decelerate.

The data from the manufacturing sector and the plastics industry corroborated this decline in economic growth. And this decline was especially apparent in the data for consumer spending for goods, both durable and nondurable.

In the first quarter of this year, the overall inflation-adjusted growth rate for consumer spending on goods actually contracted by 2.3 percent. This was a major point of concern for me as well as the entire plastics industry, and I said so at the time.

But this contraction in the data for spending on goods in Q1 reversed in the second quarter, and it registered a nice uptick of 2.5 percent. I was particularly heartened to see that growth in expenditures for durable goods rebounded by 4.7 percent in the second quarter after an uncomfortable drop of 4.5 percent in the first three months of this year.

Growth in consumer spending for services exhibited a moderate tick down to 2.2 percent in Q2 after a gain of 3.3 percent in Q1. But the overall gist of the report is that consumers are still spending at a decent pace and the pattern of spending is a good balance between goods and services.

As the graph indicates, the growth rate for personal consumption expenditures has been solid and steady for the past year or so. You can see the growth is about the same as it was before the pandemic. And all of this has happened while interest rates were high by the standards of recent history.

The overall positive tone of this report notwithstanding, there are sectors of the economy that remain worrisome. Most notably, residential fixed investment (spending on houses) contracted 1.4 percent in the second quarter. This is a major indicator of demand for many types of plastics products.

This decline follows an outsized jump of 16 percent in the first quarter, so the decline in the second quarter was likely a short-term payback or, said another way, a reversion to the mean. But I have expressed my concerns about the overall health of the residential construction sector numerous times in recent years, and the latest GDP report does little to assuage my long-term anxiety. This sector is still not right. Until the trend in housing starts returns to a normal state of equilibrium, this sector will remain a drag on the trend in the data for the plastics industry.

Finally, there was a decline registered in investment in industrial equipment in Q2. This is the sector that includes investment in plastics machinery. Plastics machinery accounts for a small proportion of this category, but higher interest rates have clearly been a drag on investment in all types of industrial equipment.

Based on this latest GDP report, and also the latest trends in the other measures of inflation and employment, I believe the most likely scenario is that the Fed will reduce interest one or two times this year. This implies that the overall interest rate environment will remain restrictive but that the economy will continue to chug along thanks to the consistent spending pattern of American households.

As I stated at the beginning, there is plenty of risk to this outlook. But as of now, the probabilities favor an outcome that is neither urgent nor dramatic. To me, that is the definition of a soft landing.

But do not take this outcome for granted because we have not yet actually landed. Until the Fed gets its interest rate back to a neutral level, there is still a chance the landing will be something other than soft. Until then, monitor the behavior of U.S. consumers closely. They are the key.