Q2 GDP revised lower despite modest uptick in estimated household consumption

As the Commerce Department continues to refine its data, the growth picture for Q2 is also gaining clarity. Today’s release suggests that the economy didn’t meaningfully accelerate during the second quarter but was able to sustain its momentum. That doesn’t mean there weren’t meaningful changes bubbling under the surface.

The economy grew at a downwardly revised 2.1% annualized rate in Q2 — fractionally stronger than its 2.0% Q1 pace. The first estimate released in late July had come in at 2.4%.

Growth has seemingly settled into a more normalized range over the past three quarters following more than two years of volatility. Still, there’s evidence that the subtle contours of the path are still adjusting. The resilient U.S. consumer sector has provided a key underpinning to growth for some time, although its relative contribution slipped in Q2, accounting for just over half of top-line growth. Spending by state and local governments also provided a boost.

One notable potential warning sign in the report focused not on the nation’s output, but on income. Gross domestic income (GDI) increased at a lackluster 0.5% annualized pace — better than the negative readings for the last two quarters, but still soft by historical measures. Tight labor market conditions drove a surge in wage gains in recent years, but high consumer inflation diluted the real benefit to workers.

Over time, GDI and GDP are expected to converge, making the notably wide gap between recent readings worth watching. Both gauges provide some insight into the relative strength of the economy. Over time, real income growth would need to be stronger than its recent pace for the economy to operate near its long-term potential. Inflation has been a significant headwind to purchasing power and real income in recent years, and while its impact is fading, the inflation genie is still not yet back in the bottle.

The reality of the current state of the economy is likely in the middle: not as strong as headline GDP alone would suggest, but not as weak as the tepid real income numbers would either. For now, consumers have been able to tap credit and draw down savings to increase their spending even after adjusting for the impact of higher prices. How long might that continue? That remains to be seen; the answer may hold the key to the lingering debate over whether the economy is headed toward a hard landing or a soft landing in the near term.

The good news for consumers is that inflation is rapidly receding. The bad news is that an increasing number of households have chewed through their excess savings and tapped credit cards aggressively to spend. That will limit their ability to spend going forward, particularly if wage growth falters and labor conditions continue to cool.

What will this mean for the markets? To the extent that investors view any signs that the economy is moving into a “not too hot, not too cold” phase that could bring an end to Fed tightening, it could be viewed as a positive, at least briefly. Coincident indicators have suggested that the economy may have lost momentum, but not nearly enough to sound alarm bells.

The risk is that the deceleration blows through the goldilocks range and edges into unambiguously “too cool.” Leading indicators remain problematic to the soft landing argument, still pointing to a likely recession that may be delayed but may not be avoided.

Has the Fed done enough already or perhaps done too much — an overshoot that may only become apparent as the impact of monetary tightening catches up with the rapid string of rate hike announcements since 2022? Or will inflation become stuck uncomfortably above the central bank’s 2% target, nudging policymakers to tighten further in the coming months?

Stay tuned.