Has the U.S. economy finally shifted into the next gear?

INDICATOR » Third Quarter GDP and Weekly Jobless Claims KEY DATA » GDP: +3.5 percent; Consumption: +1.8 percent/ Jobless Claims: 287,000 (up 3,000) IN A NUTSHELL » “The economy just may have shifted gears before anyone expected and the firming in the labor market provides hope the strong growth can continue.” WHAT IT MEANS » I have been arguing for a while now that the underlying economic fundamentals are improving rapidly and the economy should be shifting into higher gear soon. That shift may be taking place already. Economic activity expanded by a better than expected pace in the third quarter and the report was not filled with too many headscratchers. Consumer spending remains disappointing and the weak link is still services. Of course, this is the biggest individual component of GDP, accounting for two-thirds of consumption and 45 percent of all economic activity. It is hard to grow rapidly if people don’t purchase things like housing, utilities, medical care or recreation services at a decent pace. So, where did growth come from? Business investment was solid, growing at sustainable paces for equipment, structures and technology. The housing market improved, though residential investment was nothing spectacular. We shipped a ton of goods overseas while cutting back on our demand for foreign products.

Major reductions in oil imports are really a great boon to growth as we are keeping an awful lot of money in the U.S. The government is back in the spending business with national defense leading the way. That was probably make-up for all the cuts made earlier in the fiscal year. But nondefense purchases rose as well and state and local governments continue to translate growing revenues into increasing spending. Inflation remains muted and actually decelerated fairly sharply. I suspect the Fed members were not pleased to see that.

One reason I am so optimistic about the economy is my view that the labor market has already tightened and stronger wage gains are in sight. While jobless claims edged up last week, the level remains extremely low and it really does look like the October jobs report could be better than the September one, which we all agree was quite good. MARKETS AND FED POLICY IMPLICATIONS » The Fed ended quantitative easing yesterday, pointing to improving economic and labor market conditions. What could encourage the FOMC to start raising rates in the spring, as I expect, is continued strong economic growth, which leads to really tight labor markets. With consumer confidence rising, falling gasoline prices creating fatter wallets, job gains accelerating, unemployment declining and incomes rising, the holiday shopping season is setting up nicely. The National Re- tail Federation expects demand to rise by 4.1 percent this season, up from 3.1 percent last year. I think that may be conservative. I am in the 5 percent range. That could lead to a rise in fourth quarter consumption, powering growth back to the 4 percent range. A string of 3 percent or more growth rates, which the Fed will likely be staring at when it meets in January, coupled with an unemployment rate closing in on the 5.5 percent full employment rate, should be enough for most Fed members to throw in the towel. Investors will have to start balancing the reality of rate hikes in the first half of next year with better growth. We will find out then if it was the Fed or the economy that generated the outsized equity market gains over the past few years.

Joel Naroff Columnist