This edition identifies the drivers of the real gross domestic product (GDP) annualized growth during the second quarter of 2018 and discusses the sustainability of annualized GDP growth above 4% going forward.

KEY TAKEAWAYS
• Real gross domestic product (GDP) grew at a 4.2% annualized rate in the second quarter
• Quarterly GDP growth rates are more volatile than year-over-year GDP growth rates
• Most of the second quarter’s GDP growth surge came from consumption spending and exports
• GDP growth is likely to come in at around 3% for all of 2018 and may go below 3% in 2019
• Expansion of real GDP is the single most important driver of employment growth

Real gross domestic product (GDP) increased at a 4.2% annualized rate during the second quarter of 2018 as reported by the Bureau of Economic Analysis. This is a jump of 2.0 percentage points from the 2.2% annualized increase in real GDP during the first quarter. Real GDP is the value of goods and services produced by the US economy measured at constant prices and is the single most important driver of national employment. If GDP growth remains high, then employment growth will follow, in turn leading to increased payroll and workers compensation premium.

Looking back over the past several years, how remarkable is last quarter’s GDP growth rate? What are its drivers? And most important, is annualized GDP growth above 4% sustainable going forward? GDP growth varies quite a bit from one quarter to the next, as seen in Figure 1.Annual Rate = (1+Quarterly Rate)4 - 1 Much of this volatility comes simply from expressing quarter-over-quarter changes as annual rates. Annualization amplifies quarterly fluctuations in the expenditure categories that comprise GDP. Since 2012, quarterly GDP growth has been 3% or more 10 times and 1% or less six times. In both the second and third quarters of 2014, annualized GDP growth was close to 5%.

In contrast, year-over-year GDP growth rates, shown by the connected dots, tend to be more stable because they average quarterly fluctuations over an entire year. From 2012 to 2017, annual GDP growth has averaged 2.2% with a high of 2.9% in 2015 and a low of 1.6% in 2016.

Digging into the components of GDP growth helps to understand whether the last quarter marks the beginning of an upswing or just a temporary bump. From the first to second quarter of 2018 at annualized rates:Contribution from subcategories may not add to category totals due to rounding

• Consumption spending contributed 2.6%, of which spending on services contributed 1.4% and spending on goods contributed 1.2%
• Net exports contributed 1.2%
• Investment spending was essentially unchanged at -0.1% contribution due to decreased inventory investment offsetting increased investment in structures and equipment
• Government spending contributed 0.4%

The biggest drivers of real GDP growth during the second quarter of 2018 in comparison with the first quarter were consumption spending and net exports, partially offset by inventory investment. These same components also account for most of the jump in second quarter GDP growth compared to the full year 2017. Figure 2 shows growth rates for components of GDP quarterly since 2012 and highlights the 2018 second- quarter growth rate in comparison with the 2017 full-year growth rate.

What accounts for the big changes in consumption spending, net exports, and inventory investment during the second quarter?

The +0.8% bump in consumption spending relative to 2017 is largely explained by the Tax Cuts and Jobs Act (TCJA), which provided a one-time boost to income and consumption.

The dramatic 1.5% increase in net exports is largely due to threatened US tariffs. These temporarily increased exports in anticipation of retaliatory tariffs by other countries, particularly China. For instance, US soybean exports almost doubled from April to May after China announced a 25% retaliatory tariff to be imposed in July.United States Department of Agriculture, 2018, “U.S. Export Sales Reports,” 4/5-5/31 Weekly Reports, LINK Net exports decreased by $4.3 billion in July compared to June, which includes a$700 million reduction in soybean exports.

Quarterly changes in inventory investment are highly volatile. But year-over-year, inventory changes tend to average out to zero because businesses produce what they expect to sell.

Rolling back the changes in consumption spending, net exports, and inventory investment to 2017 rates would have resulted in a second quarter growth of about 3.0%.

Mainstream economic models forecast continued GDP growth, but at rates lower than 4% per year. The Congressional Budget Office (CBO) forecastsCongressional Budget Office, 2018, “An Update to the Economic Outlook: 2018 to 2028,” LINK year-over-year increases in real GDP of 3.1% for 2018 and 2.4% for 2019. The 2018 and 2019 forecasts are in-line with both Moody’s at 3.0% and 2.7%, and with the Federal Open Market Committee collective estimates of 3.1% and 2.5%.Federal Open Market Committee, “FOMC Projections Table,” September 26, 2018, LINK

While the second quarter’s 4.2% GDP growth looks to be more idiosyncratic than sustainable, continued growth in the range of 3% is nonetheless favorable for employment and wages. At 3% GDP growth, payroll covered by workers compensation will increase, although payroll growth will not be as high as it would be if the factors driving the second quarter’s GDP growth were likely to persist.

For further discussion of employment and wage growth, please see this issue’s Review of Current Conditions.