Although Inventories a Big Contributor, With Demand Growth Subd

• Real GDP increased 6.9% at an annual rate in the fourth quarter. However, much of the growth came from inventories, with demand growth less impressive.
• Consumer spending increased at a solid pace, with a smaller contribution from business fixed investment.
• Trade was neutral for growth in the fourth quarter, after being a negative in the five previous quarters.
• Inflation was at its strongest pace in decades.
• Growth should be above its long-term pace in 2022, although risks are to the downside.
• Inflation will slow in 2022.

Real GDP increased 6.9% at an annual rate in the fourth quarter of 2021, according to the advance estimate from the Bureau of Economic Analysis. This was well above the 2.3% pace in the third quarter, and the strongest growth since the third quarter of 2020 when the economy was emerging from recession after pandemic-related shutdowns in the first half of 2020.

While fourth-quarter growth was strong, demand growth was lackluster. Inventories accounted for almost 5 percentage points of annualized growth as businesses restocked after drawing down inventories earlier in the recovery. Final sales of final domestic product-GDP minus the change in inventories, which measures domestic and international demand for goods and services produced in the U.S.-increased a rather pedestrian 1.9% in the fourth quarter, although this was up from 0.1% in the third quarter.

Household demand was strong, with inflation-adjusted consumer spending up 3.3% annualized in the fourth quarter, adding more than 2 percentage points to growth. Spending growth was especially strong for consumer services. Private fixed business investment rose 1.3% in the fourth quarter, adding 0.3 percentage point to growth. There was a small decline in residential investment (homebuilding and repairs/renovations) over the quarter, with a minimal subtraction from growth.

Government spending fell 2.9% in the fourth quarter, down at both the federal and state and local levels. Government subtracted 0.5 percentage point from growth.

The trade deficit increased slightly in the fourth quarter, with large increases in both exports and imports. Trade was neutral for growth in the quarter, after five straight quarters of subtracting from growth.

The GDP price index increased 6.9% at an annualized rate in the fourth quarter, the fastest pace since 1981. The personal consumption expenditures price index was up 6.5% annualized, while the core PCE price index, excluding volatile food and energy prices, was up 4.9%. Both of these are the highest consumer inflation readings in decades.

The fourth quarter GDP report was a mixed bag. The economy expanded strongly, but most of the growth came from inventories. There was a solid increase in consumer spending over the quarter, and trade moved from a drag to neutral. But the contribution of fixed business investment to growth was modest, and residential investment was a small negative.

Growth is likely to be soft in the first quarter of 2022, as the omicron is weighing on consumer spending, particularly on services. In addition, worker absences due to omicron will be a drag on production. Growth should pick up in the second and third quarters as omicron fades, consumers spend more on services, and workers return to their jobs.

Overall the economy should expanded 3.5% this year on a Q4 to Q4 basis, about double the economy’s long-run potential. Consumer spending growth will be strong thanks to saved-up stimulus funds and a gradual fading of the pandemic. Consumer spending growth will be concentrated in services, rather than goods, although vehicles will contribute to growth as the automakers work out their supply-chain issues. Business fixed investment growth will be strong as firms spend to make their existing workers more productive given labor shortages. Housing will also contribute to growth because of strong demand for new single-family homes. The trade deficit will decline as expanding overseas economies purchase more U.S. goods and services and U.S. consumers shift away from imported goods. Inventories are still low even with the big increase in the fourth quarter and will add to growth this year as well.

Risks are to the downside. They include a possible worsening in the pandemic nd labor shortages that crimp output. The Federal Reserve could tighten monetary policy too quickly, leading to weak growth in interest-rate-sensitive industries like housing, autos, and business investment.

Inflation will slow over the course of 2022 but will remain above the Federal Reserve’s objective of 2%, using the core PCE price index. Some of the slowing will come from comparisons with 2021, rather than 2020, when prices were depressed during the early stages of the pandemic. And some slowing will come from an easing in supply-chain problems that will boost output of goods and services in strong demand coming out of the pandemic, such as cars. But even as inflation slows in 2022 it will broaden, with a wider variety of goods and services increasing in price over the year.

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