US gross domestic product (GDP) growth slowed from its pace over the previous year, falling to a 2.0 percent annual growth rate, around the economy's underlying potential growth rate but not at a pace that would narrow the economy's continued shortfall. GDP growth in the third quarter of 2021 was entirely accounted for by a slower drawdown of inventories as consumption growth was weak (with increases in services spending only slightly outpacing reductions in spending on goods) and business investment in equipment and structures fell.
Overall, the US Commerce Department reported October 28 that GDP was 2.6 percent below its pre-pandemic trend, essentially unchanged from the shortfall in the second quarter. The large increase in the trade deficit along with continued weakness in business fixed investment were the biggest sources of the shortfall. Final domestic demand, which is the total amount purchased by consumers, businesses, and government, was only 0.9 percent below its pre-pandemic trend. But US production could not satisfy this level of demand, so the difference was covered by drawdowns in inventories and a rise in the trade deficit as exports were diverted to domestic use and imports increased. In addition, price increases have absorbed much of the increase in demand as real production has run up against supply-chain bottlenecks and sluggish labor supply. Overall, the economy is in considerably better shape than was expected earlier this year, but its performance has disappointed relative to optimistic expectations from the spring and summer.
GDP is Short of Its Pre-pandemic Trend and Likely Short of Potential
In the third quarter of 2021, US real GDP was 2.6 percent below its pre-pandemic trend, as shown in figure 1. It is not necessarily the case, however, that real GDP was 2.6 percent lower than what it would have been absent the pandemic (a negative for GDP) and absent the fiscal and monetary policy response (a positive for GDP). The growth rate in the years prior to COVID-19 was boosted by continued declines in the unemployment rate as the economy's cyclical position improved. Most forecasters did not expect this improvement to continue at the same pace, instead expecting growth to slow even absent the pandemic. Our trend assumes that growth would have continued at a 2.3 percent annual rate while the Congressional Budget Office's last pre-COVID forecast was for growth at a 2.0 percent annual rate in 2020 and 2021.
In addition, the pandemic itself may have lowered potential output. Business investment fell during the pandemic and remains low. To the extent that this investment is permanently lost, the economy will have less productive capital, permanently reducing output. The cumulative reduction in business fixed investment over the course of the pandemic totals about 3 percent of the capital stock, which would be expected to reduce the level of output per hour by about 1 percent. In addition, dramatically reduced immigration and some labor force scarring have further lowered potential output. Some factors could go the other way, including the possibility of increased productivity and the possibility that output was below potential just prior to the pandemic. Overall, however, it is likely the economy's shortfall from potential is much smaller than 2.6 percent and could even be less than 1 percent.
Demand is Almost Back at Pre-pandemic Trend
Final domestic demand includes consumer spending, business investment, homebuilding, and government purchases. Overall, this demand rose only at a 1.0 percent annual rate in the third quarter as much of the production increase went towards less drawdown of inventories. Since the start of the pandemic, however, final domestic demand has been stronger than GDP. In the third quarter it was just 0.9 percent short of its pre-pandemic trend (figure 2). Moreover, to the degree that growth was expected to slow after 2019 as the economy neared or exceeded its potential, this level of demand is arguably very close to where it would have been absent the pandemic and the policy response—and possibly even above where it would have been.
The composition of demand has changed dramatically, as shown in figure 3. The biggest shortfall is in business investment, which is 6 percent short of its pre-pandemic trend, and responsible for about a third of the overall GDP shortfall. Consumer spending has also not fully recovered but is very close in aggregate, with the 0.5 percent shortfall responsible for less than a fifth of the overall GDP shortfall. Residential investment remains well above trend while government purchases are slightly below their trend.
The Biggest Shortfall in Domestic Demand is Business Investment
Although consumer spending has gotten more attention, the biggest reason that domestic demand is short of where its pre-pandemic trend would be is weakness in business fixed investment—even though consumer spending is more than four times as large as business investment. Business investment in equipment and structures fell in the third quarter as investments in intellectual property products rose. Relative to pre-pandemic trends, business investment was well below normal for transportation equipment, structures, and research and development. Business investment is elevated in information processing equipment like computers, however.
Weak supply and weak demand are likely contributing to low business investment. Prices for investment goods rose sharply in the third quarter, growing at the highest rate in nearly forty years (with the exception of some gyrations during the financial crisis of 2008). But this increase follows more muted increases in previous quarters unlike consumer prices, which have been rising strongly all year. As a result, since the end of 2019, prices for business investment have increased 1.3 percent at an annual rate, compared with 1.2 percent annual increases before the pandemic. This trend suggests that weak demand is playing a comparatively bigger role in restraining investment than it is in restraining consumer spending. But the data also indicate that supply constraints were more binding in the third quarter. In addition, both the level of interest rates and the spreads on corporate borrowing are low, another sign that investment demand is not particularly high.
While low demand seems to be a big contributor to weak business investment, the reasons for this low demand are unclear. The cost of capital is extremely low so does not appear to be a constraint on investment. One possibility is that businesses may be holding off on investment due to concerns about the Delta variant wave or the future of COVID-19. And with a possible shift towards increased work from home, some business investment, such as in office buildings or equipment, could end up on consumer balance sheets instead. The labor supply shortage could also be playing a role as, at least in the short run, new business equipment and other investment require labor to install and operate. Finally, supply constraints, including the microchip shortage and trucking and shipping delays that are complicating the delivery of new equipment, are also likely playing a role.
Going forward, business fixed investment could be an important contributor to growth. New orders for nondefense capital goods excluding aircraft have risen very sharply over the last year. Moreover, business investment tends to be negatively correlated with its recent past, with periods of weakness followed by periods of strength and vice versa.
Overall, the cumulative business investment shortfall since the onset of the pandemic totals about $1.7 trillion, which is about 3 percent of the total capital stock. That decline would be expected to reduce the level of total economy labor productivity—and of potential GDP—by about 1 percent.
The Composition of Consumer Spending Has Shifted from Services towards Goods
Spending has been highly elevated on goods and very restrained on services. That gap narrowed somewhat in the third quarter as goods spending fell at a 9.2 percent annual rate and services spending rose at a 7.9 percent annual rate. But overall, the pattern is still stark, with goods spending 9 percent above its pre-pandemic trend (figure 4). The increases in goods spending relative to pre-pandemic trends have been widespread (table 1). Based on detailed monthly data available through August, spending was more than 10 percent above trend for most durable goods categories, including used cars, motor vehicle parts, furniture, appliances, dishes and flatware, household tools, sporting equipment, recreational vehicles, musical instruments, jewelry, and telephone equipment. One notable exception was new cars, where production constraints and price increases appear to have restrained sales, keeping them slightly below trend.
Despite the large increase in the third quarter, services spending remains 5 percent below its pre-pandemic trend. About one third of the shortfall is explained by health spending, which has not returned, while low spending on transportation, recreation, and other services has also contributed to the shortfall.
|Personal Consumption Expenditures, 2021Q3|
|Difference from Trend (percent)||Contribution to Aggregate Difference from Trend (p.p.)|
|Personal Consumption Expenditures||-0.5||-0.5|
|Motor Vehicles & Parts||7.2||0.3|
|Furnishings & Household Equipment||12.2||0.3|
|Recreational Goods & Vehicles||10.0||0.3|
|Food & Beverages Purchased for Off-Premises Consumption||7.7||0.6|
|Clothing & Footwear||15.6||0.4|
|Gasoline & Other Energy Goods||-1.2||0.0|
|Household Consumption Expenditures||-4.9||-3.2|
|Housing & Utilities||0.0||0.0|
|Food Services & Accommodations||-4.5||-0.3|
|Financial Services & Insurance||5.3||0.4|
|Final Consumption Expenditures of Nonprofit Institutions Serving Households (NPISHs)||0.8||0.0|
|Gross Output of Nonprofit Institutions||-3.8||-0.4|
|Less: Receipts from Sales of Goods & Services by Nonprofit Institutions||-5.6||0.5|
|Note: Pre-pandemic trends based on log-linear regression of values from 2018Q1 to 2019Q4.
Source: Bureau of Economic Analysis via Macrobond; authors' calculations.
Domestic Production Has Not Been Able to Fully Satisfy Demand
Domestic production could not keep up with very strong demand over the course of the pandemic. As a result, much of the real increase in demand has been satisfied by drawing down inventories since the start of the pandemic, which continued to fall in the third quarter but at a slower rate (figure 5). In addition, much of the increase in durable goods consumption has been satisfied by a rising trade deficit as exports were reduced (effectively diverting some of that production to domestic consumption) and by increased imports (figure 6). Some of these patterns partially reversed in the third quarter as inventories were rebuilt.
In addition, increased demand was also absorbed by price increases. Overall, nominal GDP is just short of trend (figure 7) because price increases are well above trend (figure 8). Overall, nominal GDP increased at a 7.8 percent annual rate in Q3, slower than its 12.1 percent annualized pace in the first half of the year but still very high.
The economy is ahead of pre-American Rescue Plan Forecasts but Falls Short of Recent Optimism
The level of real GDP in the third quarter was well above all the major private-sector and official forecasts made prior to the American Rescue Plan, including by the Congressional Budget Office, Survey of Professional Forecasters, and the Organization for Economic Cooperation and Development, as shown in figure 9.
But the level of real GDP is well below the more optimistic forecasts made over the spring and summer as shown in figure 10. In August of 2020, forecasters were projecting that the economy would still be considerably smaller in the third quarter of 2021 than it was in the fourth quarter of 2019. Since then, forecasters have raised their forecasts as the recovery continued and Congress passed additional fiscal support. By the spring of 2021, after the passage of the American Rescue Plan, forecasters had become much more optimistic, predicting that the economy would have been 2.9 percent larger than it was at the end of 2019. While forecasters moderated their expectations over the summer, they still expected the economy to be about 1 percent larger in the third quarter of 2021 than it actually was.
What This Means Going Forward
The single biggest constraint on the economy in the third quarter appears to have been the inability of supply to adjust as quickly as demand. For example, the number of ships waiting to dock continued to increase over the summer even as container import volumes at the five top ports in the first eight months of 2021 were up 19 percent from 2019. In some cases, there were negative supply shocks, like reductions in microchip and other production due to COVID-19 in Southeast Asia and due to the electricity crisis sweeping Chinese factories. Perhaps the biggest constraint on supply has been workers not returning to the labor force and taking jobs as reservation wages remain highly elevated in the face of record job openings and rapid nominal wage growth. All of these supply constraints should fade eventually but how long they will take to fade is unclear.
The second biggest constraint on the economy in the third quarter appears to have been the Delta variant. Monthly data indicate that restaurant spending continued to increase over the quarter and roughly normalized but other in-person services like travel and live entertainment either experienced setbacks or did not enjoy the growth they otherwise would have. The dynamics of COVID-19, Americans becoming increasingly inured to the virus, and booster shots should all help reduce some of the constraints the virus has placed on the economy in the coming months. But there is considerable uncertainty about additional virus variants and the persistence of behavioral changes.
Demand was not as extremely strong as it was in the first half of the year when fiscal support totaled about 14 percent of GDP. But demand did remain strong in Q3. Given large cash balances, an additional $500 billion of fiscal stimulus spending out this fiscal year, and virtually unprecedentedly accommodative monetary and financial conditions, it could remain strong going forward. To the degree that it remains very strong, demand should continue to put substantial upward pressures on inflation. This trend could keep inflation above the Federal Reserve's 2 percent target for a sustained period of time—especially if the supply side of the economy does not adjust quickly.
The easiest phase of growth is well behind the US economy. Going forward, it will be tougher to make up for the remaining lost ground, especially to the degree that the virus stays at a relatively high level. But there is no reason the economy cannot continue to grow well above its underlying potential rate as it continues to close the gap between where it is today and its full potential.