US GDP Shrinks in Q4. How to Interpret the Bad News?
Data released today by the Bureau of Economic Analysis showed a decrease of 0.1 percent in U.S. real GDP for the fourth quarter of 2012. If confirmed, that would mark the first quarterly drop in real GDP since the recession ended in mid-2009.
Of course, we should always take the advance estimate of GDP with a grain of salt. The data that go into it consist largely of preliminary observations from early in the quarter, fleshed out with extrapolations of past trends. Advance estimates are subject to revisions that average plus or minus 1.3 percentage points. In this case, however, even an upward revision of double the average would represent a slowdown from the 3.1 percent growth rate of Q3.
How should we interpret the bad news? One way to go about it is to break out the contribution to growth of each major sector of the economy, as in the following table.
As we can see, consumers were not to blame for the slowdown. In fact, consumption contributed more to GDP growth in the fourth quarter than in the third. The data are seasonally adjusted, so the greater contribution of consumption does not just reflect normal holiday spending, but rather, a better than average holiday season.
Fixed investment also did well. The 1.19 percentage point contribution to growth by fixed investment was about double the average since the end of the recession. Equipment and software made the largest contribution, followed by residential investment. Both categories improved relative to Q3.
Inventory investment was another matter altogether. After contributing a positive .73 percentage points to growth in Q3, inventory investment turned sharply negative. The reversal came entirely from nonfarm inventories. In Q3, a drought-induced decrease in farm inventories partly offset strong growth of nonfarm inventories. In Q4, farm inventories recovered slightly but nonfarm inventories fell substantially.
It is always hard to interpret inventory changes. The optimistic way to tell the story would be to say that firms stocked up during Q3 in expectation of stronger sales ahead, but then when Q4 sales of consumer goods, business equipment, and construction materials grew even more than expected, inventories decreased. If that is what is going on, we would expect a boost to production early in 2013 as firms try to rebuild depleted inventories. However, a pessimist could interpret the Q4 numbers differently, saying firms are purposely running down their inventories in expectation of weak sales ahead.
The biggest single factor in the Q4 slowdown was the whopping -1.33 percentage points from the government sector, in contrast to a 0.75 percentage point positive contribution in Q3. To interpret those numbers, it is helpful to look at the behavior of the government sector throughout the recession and recovery, as shown in the next chart.
The chart shows that the most anomalous data point is not the negative contribution of the government sector in Q4, but rather, the positive contribution in Q3. The swing upward and then down again was almost entirely concentrated in federal defense spending. Meanwhile, there is actually some good news beneath the surface. State and local governments, which were making a strong negative contribution to GDP growth throughout 2010 and 2011, have largely stopped shrinking. Still, looking ahead, we can expect defense spending to remain weak as the war in Afghanistan winds down. With continued budget pressures on nondefense spending at all levels of government, we can expect the government contribution to GDP growth to remain negative in quarters ahead.
Net exports were the third sector contributing to the decrease in Q4 GDP. As the next chart shows, exports had been a bright spot in the performance of the U.S. economy throughout the recovery. The negative contribution of exports in Q4 2012 was the first since Q1 2010. The -0.81 percentage point contribution of exports was partly offset by a .56 percent decrease in imports, leaving a -0.25 percentage point contribution for net exports. (Imports are recorded in the national income accounts with a negative sign, so that a positive contribution of imports to GDP growth corresponds to a decrease in the volume of imports.)
Looking ahead, the decrease in exports is definitely not good news. It suggests that weak growth in the economies of U.S. trading partners is beginning to have a negative effect on growth of the domestic economy. The most hopeful thing we could say is that the advance estimate of Q3 GDP also reported a decrease in exports, which was revised up to a small increase when more complete data became available. Perhaps the number for Q4 will also be revised upward in coming releases.
The bottom line: There is really very little good news in today’s GDP release. A month ago, when Washington was fixated on the drama of the fiscal cliff, economists were warning that a sudden dose of fiscal restraint could cause renewed recession in early 2013. If we take today’s data at face value, there is reason to worry that a recession may already have started. That is all the more reason to avoid administering a heavy dose of front-loaded fiscal consolidation during the next round of budget negotiations.
5 Responses to “US GDP Shrinks in Q4. How to Interpret the Bad News?”
Is there a way to decompose the data and determine the effects of Hurricane Sandy on Q4 GDP?
I have not seen anything very convincing on this. The White House makes a vague claim that the storm "disrupted economic activity," but what does that mean? Things like residential construction and industrial output don't seem to have been affected, and jobs held up well i Q4. Anyone out there have a good answer?
Decompositions are problematic. For example, reducing imports will, by itself, reduce
GDP. However, the way the government collects data money spent on imports appears in more than one spending category. Consumption expenditures (C) include all spending on consumer goods, whether imported or domestically produced. The same is true for investment spending and spending by government agencies. They all include spending on imports. Thus, a reduction in the value of imports will not necessarily reduce GDP, since it would get subtracted from imports but also subtracted from consumption, investment, or government spending.
There is also Bastiat's famous point about broken windows. Some people had observed that windows broken by storms created jobs for construction workers.
Bastiat observed that if these jobs are beneficial, more jobs could be created by deliberately breaking windows.
It has also been commonly observed that governments tend to blame reduction in GDP
and increases in inflation on natural disasters, such as hurricanes and earthquakes, rather than blunders in economic policy.
Aren't we just measuring the change from one quarter to another?
If you want to focus on Q4 you would have to look back at Q3. (One quarter vs. another is as micro as it gets)
To me, making economic assessments on quarterly GDP reports makes about as much sense as assessing the health of companies based on quarterly earnings reports. (The flaw of the world’s best Rear view mirror)
I thought Ed's analysis was timely and helpful. Not being an economist myself. Thanks.