Resilient U.S. economy grows 4.9% in third quarter

REAL ECONOMY BLOG | October 26, 2023

Authored by RSM US LLP

Despite a bevy of headwinds, a resilient U.S. economy in the third quarter expanded at a 4.9% rate on a seasonally adjusted annualized basis and at a 2.9% rate on a year-ago basis.

The top-line rise in GDP was turbocharged by strong increases in household spending, inventory building and gross private investment.

Our preferred metric, or real final sales to private domestic purchases, which excludes inventory accumulation and net exports, advanced at a 3.5% pace.

Once one takes into account growth on a year-ago basis and real final sales excluding a one-time inventory build and weak external demand, it appears that the American real economy is advancing at or slightly above a 3% pace.

Such resilience is indicative of a strong job market, real income gains and continuing fixed business investment that cannot be denied.

The boom in household spending continued at a 4% pace, which added 2.69% to overall activity during the quarter. Gross private investment increased at an 8.4% pace and added 1.47% to growth during the July to September period.

Government consumption increased by 4.6% while the change in inventories added 1.32% to overall economic activity in the third quarter compared to the previous three months.

While economic headwinds and the sharp increase in the cost of financing payrolls and business expansion will cause job creation to slow, higher real incomes and still-elevated levels of excess savings should continue to act as a buffer for an economy that continues to outperform all expectations.

Policy implications

Given the backup in long-term yields and the risk premiums assigned to firms looking to finance expansion, we do not think that the Federal Reserve will alter the direction of monetary policy because of the top-line figure or the internals of the third-quarter GDP report.

Instead, we think that the headwinds and geopolitical tensions that are helping to drive yields higher point risks that will slow domestic and economic growth into the end of this year and early next.

We think that the Federal Reserve will and should keep the federal funds rate in a range between 5.25% and 5.5% at its November meeting.

In our estimation, the central bank should soon pivot to focus on stabilizing real long-term rates, which are sitting at 2.52%, in contrast with the 0.26% averaged over the past 10 years.

Policymakers need to prepare for the maturity wall that will hit the economy in 2025 as firms roll over five-year loans that were set at historically low rates and now face the prospect of being refinanced at rates in the high single or low double digits.

The data

Growth was driven by a 4% increase in household consumption, which was bolstered by a 4.8% increase in outlays on goods, a 7.6% increase in spending on durables, a 3.3% pace on non-durable goods and a 3.6% increase in demand for services.

Fixed investment increased by 0.8%, which was dragged down by a 3.8% contraction in equipment, which was no doubt because of rising financing costs. Outlays on intellectual property increased by 2.6%, and outlays on structures rose by 1.6%. Overall outlays on nonresidential investment declined by 0.1%. Residential investment increased at a 3.9% pace.

One of the more encouraging aspects of the report was the 2.6% increase in intellectual property outlays, which tends to drive long-run increases in productivity.

Exports increased at a 6.2% pace and imports rose by 5.7%. Federal spending increased by 6.2%, driven by an 8% increase in national defense and a 3.9% increase in nondefense spending. State and local spending increased by 3.7%.

Alternative metrics of growth point to a modestly slower yet still robust level of economic activity well over 3% that underscores the fundamental resilience of the American economy.

Real final sales increased by 3.5%, as did final sales to domestic purchases that exclude the volatile categories of inventory accumulation and net exports. Final sales to private domestic purchase that exclude government consumption advanced at a 3.3% pace. Nominal GDP increased by 8.5% in the third quarter.

Looking ahead

We expect a notable slowdown in both consumption because of high interest rates for financing durable goods, a resumption of student loan payments and the drawing down of excess savings by lower-income consumers in the current quarter. We can already observe a deceleration in discretionary spending inside high-frequency credit card spending data.

At the same time, investment is likely to ease because of the significant backup in long term yields—the U.S. 10-year yield increased by 124 basis points from 3.74% on July 19 to a recent high of 4.98% on Oct. 19—and the fact that many firms are now facing rising financing costs between 10% and 15%. Those higher costs are a reflection of an aggressive risk premium charged by lenders on top of the 5.3% overnight financing rate baseline.

It is clear in the third-quarter GDP data that rising finance costs dragged down productivity-enhancing equipment investment, and we would expect another quarter of weak outlays on software and equipment.

Market expectations using U.S. dollar swaps imply that over the next six months long-term yields will stand at 4.85%, which is down modestly from the current 4.94%. That elevated level strongly implies that gross private investment will slow.

While we anticipate that the Federal Reserve will pivot to stabilize long-term rates by cutting its policy rate in the second quarter of next year, between now and then the economy will grow at a much more sluggish pace compared to the boomy 4.9% in the third quarter.

The takeaway

A resilient American economy continued to defy expectations by growing at a 4.9% pace in the third quarter because of a series of one-time factors inside the consumption channel and because of sustained gains in U.S. labor dynamics and modest real income gains.

Growth will slow back to or below the 1.8% trend during the final three months of the year as rising financing costs take their toll, as seen in the reduced equipment spending. These dynamics will most likely create the conditions for a sluggish pace of growth over the next six months until the economy adjusts to higher cost of doing business compared to the past two decades.