Growth in US domestic demand suggests solid economic growth will continue

The market perception is correct that global influences and the high greenback are biting into near-term economic growth. Third quarter real GDP is tracking only 1.5% (annualized), about a percentage point less than what was expected just one month ago. However, this headline masks a strong undercurrent in domestic demand. 

Private domestic demand - spending by households and businesses - is on pace to grow by over 4.0% (annualized) in the third quarter, similar to the outturn in the second quarter blockbuster GDP report. There are two meaningful interpretations here. First, domestic demand strength has demonstrated persistence. Over the past two years, it has grown by an average pace of 3.5%, and the more recent data is showing acceleration. Second, the strong growth in the current quarter is a good predictor of future economic growth. According to analysis by the Council of Economic Advisers, among GDP components, private domestic demand growth in the current quarter is the best predictor of GDP growth the following quarter.2 This is in contrast to indictors that have dominated the market's focus lately, mainly exports/manufacturing and inventories (two factors that will weigh on near-term growth). Both are highly volatile and have virtually no ability to explain future economic growth.

There is good reason to expect this strength in domestic demand to continue. The benefit of lower energy prices has only begun to diffuse through the economy and has been offset to-date by the decline in capital spending in the oil and gas sector. For consumers, the saving at the gas pumps amounts to a 0.7 percentage point lift to after-tax income growth (or roughly $800 extra dollars in the pocketbook). Initially households appear to have saved some of the windfall, but after peaking at 5.2% in the first quarter, the personal saving rate has since fallen to 4.6%. In the third quarter, the spending impetus came through loud and clear with auto sales rising to 18.1 million, their highest level in over a decade.

A final but important point is that even with real GDPgrowth of just 1.5% in the third quarter, it is still on track to meet the Fed's own projections on an annual basis. Achieving the Fed's median projection of 2.1% for 2015 will require fourth quarter growth of just 2.2%. Given the strength in domestic demand and the continued boost to domestic purchasing power from low energy prices and a strong dollar, this is more than achievable.