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Weak Wage and Income Growth Is Holding Consumption Back

After feeble GDP growth in the first half of the year, third-quarter data came out a little stronger, suggesting that the recovery is continuing and the risk of recession is reduced. According to the advance estimate from the Bureau of Economic Analysis, real GDP grew at a 2.5 annualized percent rate in the third quarter, accelerating from its 0.8 annualized percent growth rate in the first half of the year. Real private domestic expenditures, the share of GDP that includes private consumption and investment and excludes government spending and net exports, also accelerated from 2 percent to 2.7 percent (both annualized growth rates) from the first half of the year to the third quarter.

Figure 1. Real GDP and Private Domestic Expenditures

Even though third-quarter growth looks stronger, the pace of the recovery continues to be slow. Over the past year, real GDP grew only 1.6 percent, much less than is typical during recoveries. Real private consumption, which accounts for 70 percent of GDP, also grew slowly—only 2.2 percent in the last year. One reason why consumption is rising so slowly is that personal income is rising slowly. In real terms, personal income grew a modest 2.1 percent in the last year and fell 1.6 percent in the last quarter (annualized rate). Net of taxes, household income fared even worse. Disposable personal income grew only 0.8 percent in the last year and fell 1.9 percent in the last quarter (annualized rate).

Figure 2. Real Personal Income

With disposable income barely growing, it is no surprise that household consumption is not growing much either. In fact, unless income accelerates soon, households will not even be able to sustain their current low rates of consumption growth for long. Household consumption is currently growing at a higher rate than income. This is possible only because households are lowering their saving rate—the saving rate dropped from 5.2 percent last year to 5.1 percent last quarter and to 4.1 percent this quarter. This pattern cannot continue indefinitely. Either household income will pick up, or households will have to cut back on their consumption growth to avoid further declines in the saving rate.

Figure 3. Personal Saving Rate

The main reason household income is not growing at a stronger pace is that wage growth is stagnant. Real employee compensation grew only 1.1 percent in the last year and decreased 0.6 percent in the last quarter (annualized rate). Compensation peaked in early 2008, fell more than 5 percent during the recession and is still 3.1 percent below that peak, depressed by sluggish employment and wage growth. It has been lagging relative to other components of national income—the ratio of employee compensation to national income, the labor share, has been decreasing steadily since the end of the recession, and is currently 62 percent, the lowest level in more than forty years.

Figure 4. Real Employee Compensation

While household consumption is growing slowly, business investment is in better shape. Real fixed investment grew a solid 7.8 percent in the last year, driven by 10 percent growth in investment in equipment and software. Investment growth in the future could be fueled by corporate profits, which have rebounded strongly from their recession levels. In real terms, corporate profits have almost doubled since their lowest point during the recession, and they are now in line with the pace of previous recoveries.

Figure 5. Real Corporate Profits

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