Second Quarter GDP Disappoints

Real GDP came in at a 6.5% annual rate, well below expectations for nearly 8% growth in the second quarter. The economy easily sailed past the peak last hit during the fourth quarter of 2019 despite the disappointment in overall gains. The gap between nominal and real growth was the largest since 1981 when inflation was just beginning to abate.

Federal Reserve Chair Jay Powell reasserted his view this week that inflation, which accounts for that gap, will be transitory. Either current bottlenecks will abate or the Fed will have to more abruptly end asset purchases and raise rates to curb inflation.

Consumer spending drove overall gains, rising at a rapid, 11.8% annualized pace. Spending on services, which were hammered by the pandemic, dominated those gains. Spending on travel, tourism, and medical appointments delayed by the pandemic all picked up. Doctor and dental offices are reporting particularly long backlogs.

The housing market became a drag on growth, as we expected. Constraints on supplies from materials to labor delayed construction activity and put upward pressure on prices. Some first-time buyers are being crowded out of the market, despite record-low interest rates. Home buying attitudes have soured, causing mortgage applications to come off the highs we saw earlier in the year.

Business investment moderated, in part due to supply chain disruptions. Vehicle production was idled at some plants in response to the shortage of computer chips, largely from Taiwan. Investment in new structures fell after a brief reprieve in the first quarter; workers have yet to fully return to offices.

The drawdown in inventories was greater than expected. Usually this would mean more of a tailwind for the third quarter, but current bottlenecks are likely to take longer to resolve. Some sales could be lost entirely due to the lack of inventories.

Government spending is where the largest downside surprise occurred. State and local government spending fell well short of expectations, despite another round of stimulus in March. Schools were slow to reopen. Many state officials worried that funds allocated could be clawed back by lawmakers; that delayed spending. Those funds are expected to be spent later in the year and as we go into 2022. A sharp drop in payroll protection plan (PPP) loans accounted for the drop in spending by the federal government during the second quarter.

Separately, the trade deficit continued to widen as the U.S. outperformed many of its closest trading partners. The gap between the developing and the developed world widened as the Delta variant spread. What we have yet to see is what that means for the composition of trade. A pivot back into goods from services in the U.S. could keep the trade deficit stubbornly large in the months to come. Americans traveling abroad contributed to the jump in services imported; tourism abroad is expected to move up in fits and starts, dependent upon the pace of vaccinations.

Bottom Line
Overall growth disappointed, but much of the miss occurred in state and local government spending, which will be recouped later this year. A larger concern is the dampening effect that the Delta variant has on spending in the service sector through the summer months. It has already delayed the return to offices for some companies to later this year and upped the pressure on their workers getting vaccinated. We are becoming accustomed to spending during outbreaks, as Federal Reserve Chairman Jay Powell noted in his comments yesterday, but that spending has been supported by fiscal stimulus. That will wane as we enter 2022.

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