Friday, January 28, 2011

A weaker-than-expected Q4 GDP points to a stronger Q1

The government's first guess at the growth of fourth quarter GDP was less than expected (3.2% vs. 3.5%, with some expecting 4-5%), but if that is the reason for today's market selloff, then this is another good buying opportunity. GDP estimates can and do change significantly over the years, of course, but meanwhile, the main reason that Q4 growth was disappointing was that there was a large decline in inventories. As the chart above shows, inventories subtracted a full 3.7 percentage points from Q4 growth. As Brian Wesbury notes, real final sales (real GDP excluding inventories) rose at a very impressive 7.1% annual rate last quarter, with the result that:

... manufacturers and retailers underestimated consumer demand and ran down inventories dramatically in the fourth quarter. Anecdotal reports suggest that low inventory levels are having a cost in the form of lost sales. Moreover, prices are not likely to be slashed to reduce excess inventories after the holidays. What this means is that there is more room for production increases in 2011 and inflation will continue to move higher.

It is quite likely that businesses are already attempting to rebuild their inventories, but even if they manage to hold them steady, that will have the effect of boosting first quarter growth. I recall quite a few times in the past where a weak GDP number caused by inventories was followed by a stronger number in the subsequent period. It's likely to happen again.

I needed a 4% Q4 print to make my Dec. '09 prediction of at least 3% growth in 2010 be correct. If the first estimate stands, then I will have overestimated growth by 0.2%. Not too bad, but it was my optimism on the economy's growth prospects that led me to mistakenly expect the Fed to begin tightening policy last year, and to expect bond yields to be higher than they turned out to be. But just because I overestimated growth last year does not mean I need to cut my growth expectations (at least 4%) for this year. Stronger growth is likely because confidence is up, uncertainty is down (e.g., the tax cut extension passed), global growth remains very strong (e.g., China and India), fiscal policy headwinds are slowing (e.g., no more wasteful stimulus experiments), and monetary policy remains very accommodative.

Another thing I did not expect was the very small rise in the Q4 GDP deflator (0.26% annualized), which contributed to a very small rise in the nominal growth of Q4 GDP: 3.44%. The very small gain in the deflator last quarter could be just a one-time event, since as the chart above shows, on a year over year basis both the deflator and the Employment Cost Index look to have bottomed. Regardless, relatively slow growth in nominal GDP, alongside somewhat faster growth in M2 in the fourth quarter, resulted in a modest decline in M2 velocity (see chart below), whereas I had been expecting a pickup. But again, that is not a reason to get bearish on 2010. It still makes sense for velocity to pick up (confidence is improving, and the dollar is weak, which suggests that money demand is declining on the margin even as the Fed remains very accommodative), and it is also the case that M2 growth appears to be accelerating a bit.


brodero said...

Personally i believe the inventory
will be revise dup and Scott you
will be right.

Buddy R Pacifico said...

Scott, could you expand a little on "GDP deflator" definition? Also, any thoughts on Exports contributing to one/half of Q4 GDP growth?

Benjamin Cole said...

Inflation is dead.

From here, we get declining unit costs as production rises, spreading overhead out over more units. Wages are dead in the water.

With open borders, goods, services, capital and even labor will come in to USA if there is demand.

I see zero inflation for two more years, but I hope for solid growth.

I still think we are on the first leg of a secular bull market.

I don't understand today's sell-off; on the other hand, day-by-day, on crazy volumes, the program traders can and do make anything happen.

Scott Grannis said...

Re GDP deflator: this the broadest measure of inflation, covering all prices in the economy. It can sometimes be different from the CPI, but over time the two move together, with CPI tending to show somewhat more inflation than the deflator.

Re Exports: Net exports subtracted more from growth in the first three quarters of last year than they added to Q4 growth. But the general trend we are seeing is that exports are growing a bit faster than imports. This mainly reflects strong global demand for our exports, plus our companies have been able to respond and grow to meet the demand. Imports have been a bit sluggish, mainly because the US economy has been weak and demand is still far below where it should be.

Buddy R Pacifico said...

Scott, thank you.

Mark A. Sadowski said...

Nominal final sales of domestic product (NFSDP) is a preferred measure of aggregate demand by some Quasi-Monetarists (nominal GDP and final sales to domestic purchasers are two others). NFSDP rose an astonishing 7.3% at an annual rate in the fourth quarter (since the recovery began it has never exceeded 3.0%). In real terms the increase was 7.1%, the most in 26 years. I think this shows a number of things:

1) QE2 worked
2) Expectations matter (Bernanke’s Jackson Hole speech probably did more than the actual implementation)
3) There are no lags to monetary policy.

Needless to say an explicit target (e.g. NGDP or nominal NFSDP) would help much more than an arbitrary asset purchase figure. But first more people need to be convinced that 1) printing money has real effects in the short run, and that 2) something needs to be done.

By the way, I still believe fiscal stimulus works, but monetary stimulus is the only game in town these days, provided the Republicans don't kill it too. Austrians and recalculationists in general need to take a hike. I want growth.

Benjamin Cole said...

If I read St. Loo Fed tables correctly, the GDP Deflator indicates total price increases since June of 2008 of about 1.4 percent.

So, over 2 1/2 years, prices rose 1.4 percent.

Obviously, we are running inflation at well under 1 percent, if these figs are accurate.

If this keeps up, some observers will have to alter their views about what causes inflation.

My own view is that inflation is dead. If you pull out a microscope, you can see it, and if you have a telescope, maybe you can see it coming.

For now, Job One is getting the economy to go full blast.