Elon Musk Brings 4th Quarter GDP Growth to a Crawl

Musk's layoffs and the government shutdown were major factors in slowing growth

The GDP story for the 4^th quarter looked much worse than was generally expected. The big factor dragging down growth was a 16.6% drop in federal spending. Part of this drop was due to the government shutdown, but this was likely the less important factor since most government employees continued to work during the shutdown. (The 2018-2019 shutdown is barely visible in the data.)

The larger cause of the shrinkage was the DOGE cuts put in place by Elon Musk earlier in the year. This led to 170,000 federal employees being laid off in October and tens of thousands more in November and December. While the loss of government workers will likely remain in place for the near future, spending will bounce back in the first quarter as nearly all government workers are back on the job. This should mean strong growth in the federal sector for the first quarter. The rest of the economy does not look as good.

Consumption Driven by Healthcare

Consumption grew at a healthy 2.4% annual rate in the quarter, but 44.8% of that growth was due to increased spending on healthcare services. Healthcare spending continues to be a main factor driving growth. Nominal spending on healthcare services rose even more rapidly, growing at an 8.9% annual rate. From the standpoint of affordability, nominal spending on healthcare is arguably the major concern, and it is hugely outpacing income growth.

Most other categories of consumption were weak in the quarter. Consumption of housing grew at just a 1.1% annual rate. Consumption of durable goods fell at a 0.9% annual rate, driven by a sharp fall in car buying, and non-durable consumption grew at a 0.4% annual rate.

While wage growth continues to outpace inflation, it seems that consumers do feel stretched. This shows up in survey data, which consistently indicate considerable pessimism. This could be at least partly explained by rising healthcare costs, if consumers’ perceptions of healthcare inflation is more closely tied to what they pay for healthcare (premiums, co-pays, deductibles, and direct out-of-pocket payments) rather than the increase in the price of healthcare goods and services shown in official measures of inflation.

The notion of stretched consumers is consistent with the index of spending at fast-food restaurants. After rising rapidly in 2022 and into 2023, real spending in fast-food restaurants has been essentially flat since the fall of 2023.

Source: NIPA Table 2.4.6U.

I have argued that this can be a useful gauge of the consumption of non-wealthy households. While increased consumption in most areas may be driven by higher income people spending based on stock gains, it is unlikely that stock gains would significantly impact their spending at fast-food restaurants. High-income people do eat at McDonalds or KFC, but it is unlikely that they would increase their consumption at these restaurants because the value of their stocks has risen. Insofar as that story is accurate, it doesn’t look like most people are doing very well.

Investment Picture is Surprisingly Weak

Non-residential investment grew at a 3.7% rate in the quarter. Structure investment continued to fall, declining at a 2.4% rate. Factory construction fell at a 6.3% rate in the quarter. Factory construction is now 11.2% below its peak in 2024.

Equipment investment grew at a modest 3.2% rate, led by a 36.1% jump in investment in information processing equipment, clearly a result of the AI boom. Other major areas of equipment investment declined. Investment in intellectual property products rose at a 7.4% rate, led by software and research and development, also likely driven in large part by the AI boom. Investment in entertainment and artistic products declined at a 3.8 percent rate. The fourth consecutive quarter of decline.

Housing construction fell again in the fourth quarter. It stood 3.7% below its year ago level last quarter. The falloff in multifamily housing has been considerable sharper. The level of construction in the fourth quarter was 23.7% below the peak hit in the third quarter of 2023.

Trade Is Not Helping Much

Despite the Trump administration’s tariffs, the trade picture has improved only modestly. Using the third quarter of 2024 as a starting point, before fear of tariffs drove imports higher, the real deficit has fallen by $115 billion, from $1065 billion to $950 billion. It is likely to fall more in future quarters, as countries seek other export markets and some domestic production returns, but the latter effect is not likely to be large. With factory construction falling sharply, and equipment investment outside of AI related areas weak, it is hard to see much uptick in domestic manufacturing.

Inflation Remains Stubbornly High

The annual rate of inflation in the Personal Consumption Expenditure Deflator (PCE) edged up to 2.9% in the fourth quarter from 2.8% in the third quarter. Inflation in services remained at 3.3%. Perhaps even more concerning, the monthly inflation rate in the PCE for December, which was also released today, was 0.4%. While we should never make too much of a single month’s data, it certainly does not indicate inflation is on a downward course.

This puts the Fed in a difficult position. Folks who are not especially concerned about moderate inflation (3.0% counts as moderate in my book), would be fine with inflation staying at roughly its current pace. But if the Fed intends for its 2.0% target to be taken seriously, it would have to take steps to try to reduce inflation, as in raise rates and push unemployment higher. That’s a bad move in my book, but they didn’t ask.

The Two Huge Unknowns

While some of us were writing our initial assessments of the GDP report, the Supreme Court issued its 6 to 3 decision striking down Trump’s tariffs. In principle, this would be disinflationary, as the price of the affected goods would rapidly fall as tariffs are removed.

But in an angry name-calling rant against the Supreme Court justices who had voted against the tariffs, Trump promised to use his remaining tariff authority to quickly impose a 10% tariff on all imports. It is not clear how exactly this would work and whether it would literally apply to all imports. However, it seems likely that there will be little price relief in aggregate as a result of the Court’s ruling. It is also not clear how much, if any, of the tariff revenue collected to date will be refunded.

One outcome that does seem likely is that the Court’s ruling, and Trump’s erratic reaction, will further reduce other countries’ interest in making trade deals with the United States. Trump has shown as clearly as possible that under his leadership the United States is not a reliable trading partner.

The other huge unknown is how long the AI bubble will continue. As we saw with both the Internet and housing bubbles, irrational exuberance can persist for a long time. It’s not clear when or what will finally deflate the bubble and bring stock prices down to earth, but we will be looking at a very different economy when it happens.