GDP increased more than expected in Q3

Coming off a weak first half of the year, the resurgence in GDP in the third quarter was stronger than previously believed. The second estimate for Q3 GDP was revised upward to 2.9% — lifted by better consumer spending.

Personal consumption expanded by a revised 1.7% in Q3, despite persistent inflation gnawing away at household spending power. Representing over 70% of economic activity, the importance of a strong consumer sector can’t be overstated.

Despite a pickup in personal consumption expenditures, a broader look at the health of consumers and their contribution to growth is a bit murkier. The decline in residential investment accelerated in Q3, shaving 1.4 percentage points off GDP growth as surging home prices and mortgage rates choked off what had been a robust housing market. The combination of household consumption and residential investment doesn’t paint a terribly favorable picture for American households.

What’s fueling consumer spending? It’s not real income growth, which has been weighed down by the highest consumer inflation in decades. Exceptionally tight labor conditions in the past year had lifted wages, but for many Americans, the benefit of larger paychecks was lost to higher cost for food, gasoline, and almost everything else.

Consumers have managed to continue to increase spending, albeit at a slower pace, by ratcheting back savings and tapping available credit. Most households had saved more and borrowed less in the past few years, providing some dry powder for continued spending despite surging prices. That reservoir of cash will only continue to fuel spending to a point, particularly with wage gains already rolling over. The outlook for further consumer spending momentum may boil down to a race between the exhaustion of cash reserves and declining consumer inflation. Can the dry powder of excess cash keep consumers afloat until prices stabilize? Or will persistent inflation eventually wear consumers down? That answer will become apparent in the coming year.

Although still a significant challenge, there was some modestly good news on inflation in the report. The PCE deflator increased by 4.6% annualized for the quarter. While still more than double the Fed’s target, the headline increase was much more restrained than in the first two quarters this year, both of which came in at 8.0% or higher. It was also the lowest quarterly gain since the first quarter of 2021, when inflation pressures were first starting to build.

Any assessment of broad-based economic momentum based solely on stronger top-line growth should be tempered. Weak GDP in the first half of the year was arguably skewed by the inflow of backlogged imports and volatile inventory levels. Conversely, final sales to domestic purchasers have slowed considerably over the course of the year, declining from 9.5% in Q1 to 5.7% in Q3. That deceleration is notable, even if the impact in real terms is muted by the apparent easing in inflation measures.

The bottom line? The upward revision to Q3 GDP does little to change the overall assessment of the state of the economy. Underlying momentum still appears to be slowing, buffered by consumers tapping into savings to sustain spending. How long will consumers be willing to continue to do so? The answer to that may also hold the key to the broader questions of whether or not the United States is heading into a recession and, if so, when.