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Contact: Dave Orr
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July 31, 1998
First Union Economic Analysis: GDP (Product) Weak, but GDD (Demand) Still Strong

CHARLOTTE, N.C. - The government reports economic growth based on production - Gross Domestic Product (GDP). And on that basis, the second quarter was lousy, increasing at only a 1.4 percent rate from the first quarter of this year.

But is economic activity really that weak? Not if measured by U.S. demand for goods and services, (Gross Domestic Demand, or GDD), which rose at a strong 6.4 percent annual rate. The difference is that the demand was met by firms selling out of inventory as well as by consumers and companies buying more imported items (not produced in the U.S.), while foreigners bought fewer items produced here.

"Which is more important, production or demand for products? In some ways that is a circular 'chicken and egg' question; but in our view, demand is the real key," said David Orr, chief Capital Markets economist for First Union. "So long as demand continues to grow -- which we think it will -- the production weakness should be temporary. The Asian and GM impacts will likely keep the third quarter production figures subdued as well, but by yearend, the ongoing strength in demand should pull production growth, GDP, back above 3 percent again."

The second quarter real growth in demand showed consumer spending up at a 5.8 percent annual rate, business investment rising 11.4 percent, residential housing increasing 13.2 percent and government purchases climbing 3.7 percent. Those positive demand factors were offset by:

$46.7 billion less inventory building in the second quarter than in the first quarter ($44.7 billion vs. $91.4 billion). This subtracted 2.5 points from GDP;
and a $54.4 billion worsening of the trade deficit ($252.9 billion vs.$198.5 billion), which subtracted another 2.9 points from GDP. Orr noted that the data and measurement techniques for inventories and net exports (exports minus imports) are extremely volatile on a quarterly basis. Looking at demand results in a more consistent picture of the underlying trends, he said. Private sector demand accounts for 85 percent of the total, but often the quarterly swings in real GDP are greatly exaggerated, both up and down, by the vagaries of inventories and net exports; it's "the tail wagging the dog" story.

One way around that problem is to focus on the year-to-year change in real GDP, rather than on the quarter-to-quarter annual rate reported as the headline figure. All corporations report their earnings on a year-to-year basis, and many people assume that is the case for GDP as well. The distinction is more than academic, as the year-to-year growth of real GDP in the second quarter was 3.5 percent. While that is a bit slower than the 4.2 percent year-to-year rate of the first quarter, Orr said the 3.5 percent figure is a better reflection of the underlying trend of economic activity than the reported headline of only a 1.4 percent gain.

"We do not mean to treat causally the threat of a more serious, longer-lasting slowdown in the economy induced by the Asian crisis; that would push up unemployment to 5 percent by yearend and take a bite out of consumer confidence," Orr said. "That view is held by some very savvy forecasters and is certainly a possibility. At present, however, we side with Mr. Greenspan's recent comments, which portray this mid-year softness in GDP as narrow in scope and transitory, not the harbinger of a widespread and enduring malaise. We think Mr. Greenspan will be as stubborn about not lowering interest rates while GDP is weak as he was about not raising rates while GDP was very strong. Inflation is his bogey - not growth."

Orr is a senior vice president in economic research in First Union's Capital Markets Group. First Union Corp.(NYSE:FTU) is a leading provider of financial services to more than 16 million retail and corporate customers throughout the East Coast and the nation. At June 30, 1998, First Union had assets of $229 billion.

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