The economy grew 2.9%. Demand barely grew at all

The advance estimate put fourth-quarter US GDP growth at 2.9 per cent annualised, comfortably ahead of forecasts, and commentators were quick to praise the economy's resilience. The composition tells a different story. Nearly half the growth came from businesses piling up inventories they had not meant to hold, while final sales to private domestic purchasers, the cleanest gauge of what consumers and companies actually want to buy, crept up at a feeble 0.2 per cent annualised rate.

A year of odd numbers

The figures have been confusing all year. GDP shrank in the first and second quarters of 2022, prompting a summer argument about whether America was in recession while employers were still adding hundreds of thousands of jobs a month. The economy then grew in the third quarter, helped by a surge in net exports, and now again in the fourth. The headline has swung around on lines that say little about underlying demand, which is why the composition deserves more attention than the total.

Growth sitting in warehouses

Inventories are among the most volatile and misleading lines in the national accounts. When retailers and manufacturers cannot sell their goods because demand is cooling, the unsold stock is counted as inventory investment, which mechanically lifts GDP.

Goods that nobody wants are working capital stuck on corporate balance sheets, and they add nothing productive. In the fourth quarter, inventory building contributed 1.46 percentage points of the 2.9 per cent growth figure.

The accounting explains why. GDP measures production, and a pair of trainers made in the quarter counts whether it is sold or sits on a shelf. What matters for next quarter is whether the stock was wanted. Large retailers spent much of 2022 complaining about excess inventory after supply chains unclogged and shoppers switched from goods back to services, which suggests a good part of this build was involuntary.

Borrowed from next quarter

Future output will pay for it. Businesses will cut factory orders and offer discounts to clear full warehouses, so the stockpiling of late 2022 amounts to growth borrowed from early 2023. It is likely to be repaid with falling production over the next few months.

There is a recent example of exactly this pattern. The advance estimate for the fourth quarter of 2021 showed growth of 6.9 per cent, with inventories accounting for 4.9 percentage points of it, and the first estimate for the following quarter showed the economy contracting. Factories are already feeling the turn: the ISM manufacturing index fell below 50 in November, the level that separates expansion from contraction, and stayed there in December.

Private demand stalls

Strip out the swings in inventories and net exports and domestic demand has all but stopped growing. Fixed investment fell sharply, dragged down by the continuing slump in housing, and business spending on equipment shrank.

Housing is where the Fed's tightening has hit first and hardest. Thirty-year mortgage rates more than doubled over 2022, climbing above 7 per cent in the autumn, and home sales and construction have fallen steeply in response. Equipment spending matters for a different reason: it reflects what companies expect demand to look like a year or two out, and they are clearly less confident than the headline suggests.

Consumer spending on goods declined, leaving total consumption leaning on services that households cannot easily do without. Spending on services still rose, but much of it goes on rent, healthcare and other items that households cut only under duress. The discretionary part of the budget, where a slowdown shows first, is the part that has stopped growing. Real wages fell for most of 2022 as inflation outran pay, and households have been running down the savings built up during the pandemic to keep their spending steady.

Net exports flattered the figures too. Imports fell as American demand for foreign goods cooled, and because imports are subtracted in the national accounts, a drop in them adds to measured output. A country buying less from abroad because its consumers are retrenching is hardly showing strength.

The industries most exposed are the ones that ordered heavily during the pandemic goods boom: furniture, electronics, clothing and home improvement, along with the trucking firms and warehouses that move their products. Companies in these businesses must choose between discounting, which squeezes margins, and cutting orders, which squeezes suppliers. Either way, their earnings in the first half of 2023 look vulnerable.

The case for resilience

The optimists point to the labour market. Unemployment was 3.5 per cent in December, matching a half-century low, and payroll growth has slowed but not stopped. With jobs plentiful and wages rising, the argument goes, households will keep spending even as goods demand cools, and inventory corrections in the past have often been short and shallow. That is a fair reading, and it explains why many forecasters still expect a soft landing.

The trouble is timing. Employment tends to lag the cycle, so a strong jobs market describes the demand of recent months rather than what comes next. Interest-rate rises take a year or more to work through, and much of last year's tightening has yet to reach company budgets.

What would change the call

The next few releases will settle the argument. Monthly retail sales, the ISM indices and initial jobless claims will show whether demand is sinking or merely pausing. The second GDP estimate, due next month, will revise the inventory figures, and the Fed meets at the start of February, when markets expect a smaller rate rise than in December.

If final sales to private domestic purchasers rebound in the first quarter, the inventory build will look like prudent restocking rather than a glut, and the gloomier reading will have been wrong. That would require households to start buying goods again, something the January retail figures will begin to reveal.

The 2.9 per cent headline flatters an economy whose private demand has stalled. With almost no cushion left, any further Fed rate rises could tip output lower in early 2023. Expect the inventory build to reverse in the first half of the year, with manufacturers and goods retailers taking the first hit and the headline GDP figure for the first or second quarter printing close to zero or below it.