Friday, January 29, 2010

Fourth Quarter GDP Consistent With a Moderate Recovery

The press headlines so far uniformly highlight that the 5.7% annualized growth rate for Q4 GDP is the highest in six years, which is factually true. But this morning's report is also a textbook-like case of the hard reality that, after all is said and done, GDP numbers are a "bean counting exercise". This means that GDP consists of a number of components, each one of which is subject to a high degree of noise from one period to the next, and, at times, those multiple sources of noise can present a distorted picture of what is actually going on.

Source: Bloomberg, Haver Analytics

The primary reason for the seemingly impressive growth rate last quarter was a dramatically slower pace of inventory liquidation, which added 3.4 percentage points to the overall GDP number, following a far more moderate contribution of 0.7 percentage points to the previous quarter's growth. Outside of inventories, real final sales (that is, overall GDP minus inventories) grew at a relatively subdued 2.2% rate.

Personal consumption rose 2% (following a 2.8% pace in Q3) contributing 1.4 percentage points to growth, while capital spending was up 2.9% (its first increase since Q2 2008), indicating an end to its free-fall in the prior five quarters. Net exports also contributed 1/2 a percent to growth, as imports declined sharply for the quarter.

Despite its impressive fourth quarter number, GDP contracted by 2.4% in 2009 compared to the previous year.

Now, inventory replenishment is a natural part of the turnaround in economic activity in any business cycle, as it represents the legitimate adjustment of businesses to the reality of stirrings in final demands following a recession. In that context, this is precisely what has been happening again in this cycle. In fact, this inventory adjustment process goes hand-in-hand with a pick up in underlying production, which is one of the key dynamics that set into motion an economic recovery. So, nothing wrong with that, per se. Still, it does deflect some attention from the reality that today's report shows most of the other GDP components recovering at an appreciably slower pace and remains consistent with the prospect of an overall moderate economic recovery ahead.

As the inventory rebuilding process is unlikely to be sustained in the coming quarters at the pace of the most recent period, GDP is likely to cool to 3.5% or so in the first half of the year, which would be roughly in line with the average growth in the second half of 2009 (3.9%). Although inventories should remain a net contributor to GDP in the quarters ahead, all eyes are now turning to personal consumption- and, to a lesser extent, capital spending- which will ultimately determine the kind of recovery that is in store for 2010.

Anthony Karydakis

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