Atlanta Fed Confirms Economic Slowdown

Executive Summary

• The Atlanta Fed GDPNow model has reduced the estimate for third-quarter GDP from over 6% to 3.7%.

• Inflation increased too early in the expansion, and real growth is declining.

• A 3.7% increase in real GDP still leaves the economy with a 2.2% gap relative to the pre-COVID trend.

• Tightening monetary policy into a declining growth rate environment with an existing GDP gap is going to prove difficult.

• Watch for a flattening yield curve and an increase in the US Dollar.

Atlanta Fed Confirms Economic Slowdown

With unemployment benefits fading and the prospects for large fiscal stimulus taking a backseat to a host of other government theatrics, Wall Street has warmed to the idea that the growth rate in the economy will fall. 

Now, this does not mean the economy will be contracting, but rather that the pace of growth will fall. 

While reduced unemployment benefits or the Delta variant are the most obvious scapegoats for weaker economic growth, the reality is that the current economic slowdown was underway several months ago, with origins back to December 2020. 

In a June article, I highlighted a cyclical inflection point in economic growth based on a broad basket of leading economic indicators that had already inflected lower, long before the prevalence of the Delta variant. 

Over the past several weeks, the Atlanta Fed GDPNow model, a running estimation of real GDP growth, has been revised from a 6.3% estimated growth rate to 3.7%. 

Atlanta Fed GDPNow:

Source: Atlanta Fed

The table below shows the evolution of growth rate estimates for various components of real GDP. 

Real consumption has been revised steadily lower, falling from 3.9% in August to 2.2% in September.

The main drag on real GDP, which has caused the third-quarter estimate to be nearly cut in half, is coming from two places: equipment and residential investment. 

Atlanta Fed GDPNow Contributions:

Source: Atlanta Fed

The housing market slowdown has been underway since February as higher costs reduced building activity. The growth rate in new building permits declined from a 40% annualized rate in February to a 4.4% rate in July.

From 2009 through 2019, real GDP increased at a 2.3% annualized pace. Inclusive of the new third-quarter real GDP estimate, the economy is projected to hold a 2.2% gap relative to the pre-COVID trend. 

Real GDP Gap:

Source: BEA, EPB Macro Research

A large and persistent real GDP gap implies that the economy has excess capacity, likely in the form of labor, that will keep inflation suppressed after the current transient spike begins to fade through the end of this year. 

Reopening effects, fiscal stimulus, and supply chain disruptions contributed to a very sharp and early rise in inflation. 

Real incomes suffer when inflation rises too early in an economic expansion as corporations seek to preserve margins after economic distress. 

The chart below shows the six-month smoothed growth rate of manufacturing shipments, one of the inputs in the equipment category of real GDP. 

Manufacturing shipments growth surged as the economy reopened, rising from 0% in the summer of 2020 to 12% through the end of the year. Inflation lagged, which helped an economy recover, and the real growth rate increased. 

As prices continued to rise, inflation started to cut into real income, and the spread between nominal growth and inflation narrowed, otherwise meaning that the real growth rate was declining. 

Manufacturing Shipments & Inflation:

Source: Census Bureau, FRED, EPB Macro Research

If we deflate manufacturing shipments by the producer price index as suggested in the Atlanta Fed GDPNow model, we can see the major inflection in real growth that occurred late in 2020.

Real Manufacturing Shipments:Source: Census Bureau, FRED, EPB Macro Research

Inflation rose too early in the economic expansion and reduced real income growth. Increased stimulus payments offset this force, and real consumption growth rose, but that effect is now fading. The result is that real consumption growth is also declining. 

Coincident Economic Growth:

Source: BLS, BEA, Federal Reserve, EPB Macro Research

We can see the direction of real growth is falling in all major areas of the economy, from production to employment, consumption, and income. 

Real income growth suffered early in the expansion, which has prevented the economy from growing in real terms, leading to a persistent real GDP gap. 

A persistent real GDP gap implies excess resources in some area of the economy, and in the case of the US, that is most likely labor. 

Employment-Population Ratio:

Source: FRED

Tightening monetary policy will prove difficult with a persistent real GDP gap and a declining rate of growth. 

If the Federal Reserve continues to move in the hawkish direction with a slowing economy, we should see the yield curve flatten and the US Dollar rise, reflecting tighter financial conditions. 

Yield Spreads:

Source: Federal Reserve

The leading indicators of real economic growth and inflation will continue to guide the short-term (6-18 month) outlook, while secular economic trends will provide the foundation for economic gravity. 

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If you are interested in monthly updates on the economy's cyclical trends, click here. 

Please feel free to contact me with any questions. I am always more than glad to try and help.