Small Decline in Real GDP in Second Quarter, But Economy Is Not in Recession

Commentary by PNC Chief Economist Gus Faucher

Real gross domestic product (GDP) fell 0.9% at an annual rate in the second quarter of 2022, according to the advance estimate from the Bureau of Economic Analysis (BEA); this followed a 1.6% decline in the first quarter. This is the first time GDP has contracted in two consecutive quarters since the first half of 2020, when the pandemic came to the U.S.

The big drag came from inventories, which subtracted 2 percentage points from growth. Trade was a major positive adding 1.4 percentage points to growth in the quarter as the trade deficit declined. Exports rose a very strong 18% while imports rose just 3%; higher imports subtract from GDP. Consumer spending rose 1.0% adjusted for inflation, adding 0.7 percentage point to growth. Goods spending fell 4.4% in the quarter, with declines for both durable and nondurable goods, but services spending rose 4.1%.

Business fixed investment was essentially flat in the second quarter, with a big increase in investment in intellectual property products almost offsetting declines in investment in structures and equipment. Housing investment was a major drag, subtracting 0.7 percentage point from growth, as higher interest rates weighed on homebuilding and repairs and renovations. Government subtracted 0.3 percentage point from growth, with small declines in federal and state and local government spending.

On a year-ago basis real GDP was up 1.6% in the second quarter, down from 3.5% growth in the first quarter.

Final sales of domestic product — GDP minus the change in inventories, which measures demand for goods and services produced in the U.S. — increased 1.1% in the second quarter, following a 1.2% decline in the first quarter.

The National Bureau of Economic Research (NBER) is the widely accepted arbiter of recessions in the U.S. according to the NBER, a recession is “a significant decline in economic activity that is spread across the economy and that lasts more than a few months.” The NBER explicitly states that two consecutive quarters of contraction in GDP does not necessarily equate to recession. Instead, the NBER considers many economic series, including personal income (excluding government transfer payments) and consumer spending, both adjusted for inflation; employment; wholesale and retail sales, also adjusted for inflation; and output in manufacturing, mining, and utilities.

Using these indicators, the economy was expanding through the second quarter. The second quarter GDP results reaffirm this view, with consumer spending and final sales of domestic product both up moderately, and with inventories the major drag on growth. Demand remains solid.

Strong job growth is another indication that the economy is expanding in mid-2022; the economy added 375,000 jobs per month on average in the second quarter. Additionally, the decline in real GDP (unannualized) in the first half of 2022 was 0.7%; it is unclear if this would meet the NBER’s definition of a “significant” decline. And an alternative measure of the size of the economy, real gross domestic income (the income going to households and firms from economic activity) rose in the first quarter; the BEA will release the first read on real GDI for the second quarter next month. Real personal income excluding transfer payments rose slightly in the second quarter.

The GDP price index rose 8.7% annualized in the second quarter, up from 8.2% in the first quarter. The personal consumption expenditures price index increased 7.1% in the second quarter, the same pace as in the first quarter. The core PCE price index, excluding food and energy prices, rose 4.4% in the second quarter, down from 5.2% in the first quarter. The PCE price indices are the Federal Reserve’s preferred inflation measures and are running much higher than the central bank’s 2% objective. The central bank is raising interest rates in an effort to slow growth and bring down inflation.

Economic growth slowed in the first half of 2022, but the U.S. economy is not in recession. Demand, especially from consumers, remains solid, thanks to the very good labor market and about $2 trillion in extra saving relative to before the pandemic, and despite the drags from inflation and higher interest rates. Consumer spending is shifting from goods to services; consumers bought a lot of goods in the initial recovery from the pandemic and don’t need as many now and are feeling more comfortable going out and spending on services.

Despite a very small decline in the second quarter, business investment demand remains solid. A narrowing trade deficit will also contribute to solid economic growth in the second half of 2022. Housing will remain a drag, however, as higher mortgage rates continue to weigh on the housing market. PNC expects annualized growth in the second half of 2022 of around 2%, with growth slowing to around 1% in 2023 and 2024 as higher interest rates continue to weigh on the economy.

Although the U.S. economy continues to expand, recession risks are elevated, with a probability of around 45% over the next couple of years; this is more than double the probability before the Russian invasion of Ukraine. The risk is that Fed interest rate increases to reduce inflation could lead to an outright contraction in economic activity, either in late 2022 or sometime in 2023.