Is it code red for the economy?

Recently the US Bureau of Economic Analysis released their quarterly GDP report, the first of the year and the first during the new Trump Administration.  Normally this report is a “yawner” for most people, and only gets the attention of economists and others who track the economy on a day-to-day basis. Yet this report was different.  It motivated many to declare a “code red” condition for the economy.

What do I mean by code red?  In everyday use, code red means a dangerous and dire situation. Applied to the medical field, it tells first-responders and medical professionals to be ready for an emergency.  So, why did the GDP report prompt many to see a code red situation in the economy, and are they correct?

But before addressing these questions, what is the quarterly GDP report?   GDP stands for “gross domestic product.”   It is a measure of output – or production – of all businesses in the economy.  All types of businesses, like farming, manufacturing, and services, and spanning all activities, from delivering products, medical operations, education, and banking – to name a few – are part of GDP.  The GDP numbers are adjusted for inflation so they don’t expand just because prices rose.  Hence, the GDP numbers provide the broadest measure of collective activity in the economy.

The troubling result for the first quarter GDP report is that it showed GDP dropping.  The reduction was modest, at negative 0.3%, but it was the first drop in three years.  Immediately, concerns about a recession rose.  This is because a “rule of thumb” for declaring a recession is two consecutive quarterly drops in GDP.  Many worry another drop in GDP in the spring quarter will mean the country has been in a recession.

Recognize, however, that two consecutive quarterly reductions in GDP are not the ultimate determinants of a recession.  A group of economists working with a think-tank outside of the federal government ultimately make the decision of deciding if a recession has occurred.  Indeed, four times since World War II an official recession was not called despite two quarterly reductions in GDP, with the most recent being in 2018.  For a recession to be called, the economists consider the depth, duration, and diffusion of the economic pullback.  The last characteristic, diffusion, means the economists look for the economic decline to be spread to most sectors of the economy, rather than being concentrated in a few sectors.

There’s another reason to not yet jump on the recession bandwagon. The details of the first quarter GDP report show the decline was due to one factor – a surge in imports.  This was understandable as domestic businesses that import products from foreign countries wanted to stockpile those products before higher tariffs were imposed.  It’s domestic businesses that actually pay the tariffs. In the GDP calculation, imports are considered a negative as it is assumed imports take the place of domestic production.  If the negative import effect is removed, GDP growth in the first quarter would have been positive. In fact, most of the other elements of the GDP report, such as consumer spending and business investment, were positive.

All eyes are now turned to the second quarter (April, May, June) when the economic impacts of continuing tariffs should be felt.  Sometime during that quarter businesses that rely on imports would be expected to face the higher costs of elevated tariffs. This would likely spark two reactions.  With their costs higher, businesses will reduce production and likely reduce their workforce.  Businesses will also try to pass some of their higher costs on to consumers by raising the prices of products sold to customers.  These impacts could result in slower job growth, or perhaps even a reduction in jobs, and much slower consumer spending.  The result could be the worst of all conditions in the economy – higher unemployment and higher prices.

Hence, the second quarter GDP report will be very important to watch.  Forecasters are already placing their bets, with some predicting a slight negative result and others a slight positive result for GDP growth.

Clearly the factor to watch in the upcoming months is the possibility of trade agreements between the US and other countries.  The Trump Administration appears willing to reduce US tariffs on imported products if foreign countries reduce their tariffs on US exports.  One sticking point is the Administration’s insistence that foreign countries also reduce “non-tariff” impediments to the purchase of US made products, such as certain kinds of taxes and regulations.

If trade agreements can be made with numerous countries that will result in reducing the US imposed tariffs, the chances of higher unemployment and higher prices in the US will be reduced.  The ultimate test will be whether a trade agreement can be reached with China.

Will North Carolina be impacted by the back and forth of trade relations?  The answer is a strong “yes.”  International trading of exports and imports account for 20% of the State’s economy, slightly less than the 27% for the nation but still very significant. Over a million jobs in North Carolina are estimated to be dependent on international trade.  So, like the nation, North Carolina’s economy can sink or swim with international trade.

Hence, to know where the economy is headed, watch closely what is happening to the trade talks between the US and foreign countries.  While the negative GDP report for the first quarter is not a reason to signal a code red for the economy, many economists still think the importance of the on-going trade negotiations warrant at least a cautionary code yellow.

So, if you’re painting the economic outlook, you decide what color to use!

Walden is a William Neal Reynolds Distinguished Professor and Extension Economist in the Department of Agricultural and Resource Economics at North Carolina State University who teaches and writes on personal finance, economic outlook, and public policy.