Summary
When the first look ("advance" estimate) at second-quarter 2005 gross domestic product was released at the end of July, Wall Street bulls immediately -- emphasis on "immediately" -- heralded the report as "proof" the economy was in great shape, despite the large volume of revisions in the report requiring more scrutiny than the Street's cheerleaders possibly could have given them so quickly. PS: We are not out purposely to rain on parades, but here is an examination of some of the numbers that most of the bulls have thus far neglected.
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Introduction
John Williams and I are not out purposely to rain on anyone's parade. This said, a significant part of our collective mission is to apprise our clients of the side of various government and other economic releases that might be a bit less cheery than meets the casual eye. These are the less cheery aspects of many of these reports that Wall Street's large and vociferous corps of cheerleaders, abetted by Tout TV and the other outlets in the regular propaganda loop, either glance over or simply neglect altogether, as is more often the case.
Since John and I formed our joint research venture late last year, we have been in an excellent position to assess the number and nature of the people who find government economic data a bit "suspect" (euphemism for something perhaps a little more nefarious). Let me assure readers this group is large and growing in number, and it is represented by many people of a very high level of sophistication and investment responsibility.
So with the above in mind, let's have a look at the latest results for the nation's gross domestic product. The first part of the following material simply examines the data relating to the second quarter as the Commerce Department released it. The second part looks at the revisions that accompanied the release. These date back to the first quarter of 2002, and they cast growth and inflation in a somewhat more pessimistic light than was the case when the numbers were originally reported.
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General Observations Regarding the
Reported Second-Quarter Numbers
* On July 29th, the Commerce Department reported that real gross domestic product grew at a 3.4% annual rate during this year's second quarter. This was just slightly below a consensus estimate of 3.5%
* The three-month period ended June 2005 was the 15th consecutive quarter of reported real GDP expansion.
* According to Commerce, results were mixed during the second quarter for two of the major inflation measures associated with gross domestic produce. The overall GDP implicit price deflator was reported at a 2.4% annual rate, down from a 3.0% rate in the first quarter. Meanwhile, the deflator applied to personal consumption expenditures was reported at a 3.3% annual rate, up from a 2.9% rate in the first quarter.
* Comparing the first estimate of second-quarter numbers with the Commerce Department's final estimate of this year's first quarter, real GDP was up $92.7 billion or about 0.843%. Add one, then raise the result to the fourth power, and you get the rounded annual rate of change of 3.4%.
Nominal (Pre-Inflation) Comparisons
* Versus 2005's first quarter, 2Q2005 nominal GDP rose $177.4 billion, or at a quarter-over-quarter annual rate of 5.9%. The respective numbers: 2Q2005 = $12376.2; 1Q2005 = 12198.8 billion.
* Versus 2004's second quarter, 2Q2005 nominal GDP rose $710.1 billion, or 6.1%, year over year. The respective numbers: 2Q2005 = $12376.2 billion; 2Q2004 = $11666.1 billion.
Real (After-Inflation) Comparisons
* Versus 2005's first quarter, 2Q2005 real GDP rose $92.7 billion, or at a quarter-over-quarter annual rate of 3.4%. The respective numbers: 2Q2005 = $11092.0 billion; 1Q2005 = $10999.3 billion.
* Versus 2004's second quarter, 2Q2005 real GDP rose $387.9 billion or 3.6%. The respective numbers: 2Q2005 = $11092.0; 2Q2004 = $10704.1 billion.
* Five of the six primary GDP categories added to real growth in the "advance" 2Q2005 estimate versus the "final" 1Q2005 estimate of economic activity. In order of their dollar contribution, these were:
(1) Personal consumption expenditures
(+$63.4 billion),
(2) Net exports (+$44.1 billion), by virtue of a
narrowing in the trade deficit by that amount),
(3) Nonresidential fixed investment (capital
spending, +$27.3 billion),
(4) Residential fixed investment (housing, +$13.8
billion),
(5) Government spending (+$9.7 billion).
* The primary GDP category subtracting from growth was:
(1) Inventory change (minus $64.6 billion).
Much has been made of this large reported rundown in inventories. In turn, it contributed to growth in real final sales (real GDP less inventory change) at a 5.8% rate in the second quarter, something you would associate with very healthy, well-balanced growth. I'm simply not sure what to make of it, other than it looks a little "fluky" to me.
But bulls are using the inventory figure to assure everyone that growth in the second half will be stronger than originally forecast, since businesses must replenish inventories at a high rate. Maybe, maybe not, but there is a darker side to this bullish assumption, too, if you think about it. Because if the business sector really did run down inventories this much during the second quarter, it was inventories on their books generally at lower-than-current replacement costs for many items, particularly in some of the commodity-related areas.
As it relates to reported earnings, inventories are a tricking area, depending on the tax treatment individual firms have opted to use. The reported earnings consideration aside, if you are in business and acquiring inventories that are more expensive than the ones they are replacing, and you are in a sector that lacks so-called "pricing power," you might have a margin problem. Or if you are in a sector that does possess pricing power, then higher inventory costs have negative implications for overall inflation.
The following table breaks out in greater detail many of the numbers discussed above.
--------------------------------------------------
ADVANCE ESTIMATE OF SECOND-QUARTER 2005
REAL GROSS DOMESTIC PRODUCT (Released
7/29 -- Billions of 2000 Chained Dollars
at Seasonally Adjusted Annual Rates)
--------------------------------------------------
2Q2005 1Q2005 Change/
Advance Final Impact
------------------------
Real GDP 11092.0 10999.3 3.4%
Inventory Change -6.4 58.2 -$64.6
Real Final Sales 11096.8 10940.3 5.8%
--------------------------------------------------
Components of GDP
-----------------
Personal Consumption 7828.3 7764.9 3.3%
Nonres. Fixed Investment* 1279.5 1252.2 9.0%
Resid. Fixed Investment 597.9 584.1 9.8%
Net Exports -601.3 -645.4 +$44.1
Government Purchases* 1981.6 1971.9 2.0%
--------------------------------------------------
Implicit Price Deflators:
Gross Domestic Product 2.4% 3.0% --
Gross Domestic Purchases 3.3% 2.9% --
--------------------------------------------------
*MEMO ITEMS
-----------
Government Purchases
--------------------
Total 1981.6 1971.9 2.0%
State & Local 1247.2 1239.8 2.4%
Federal 734.2 731.8 1.3%
National Defense 489.8 487.3 2.1%
Nonresidential
Fixed Investment
----------------
Total 1279.5 1252.2 9.0%
Structures 253.0 251.0 3.2%
Equipment & Software 1041.1 1014.2 11.0%
Info. Processing
Equip. & Software 581.4 565.1 12.0%
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MAJOR GDP COMPONENTS -- CHANGES BETWEEN
"ADVANCE" 2Q2005 AND "FINAL" 1Q2005 ESTIMATES
(Billions of 2000 Chained Dollars at
Seasonally Adjusted Annual Rates)
---------------------------------------------------
2Q2005 1Q2005
Advance Final Change
----------------------------
Real GDP 11092.0 10999.3 92.7
Inventory Change -6.4 58.2 -64.6
Real Final Sales 11096.8 10940.3 156.5
---------------------------------------------------
Personal Consumption 7828.3 7764.9 63.4
Nones. Fixed Invest. 1279.5 1252.2 27.3
Resid. Fixed Invest. 597.9 584.1 13.8
Net Exports -601.3 -645.4 44.1
Govt. Purchases 1981.6 1971.9 9.7
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An Examination and Discussion of Some of the Re-
visions Accompanying the Release of 2Q2005 GDP
On July 29th, with the release of second-quarter 2005 GDP data, the Commerce Department also released so-called annual "benchmark" revisions to prior data. These covered the first quarter of 2002 through the first quarter of 2005, inclusive.
* As a general observation, GDP revisions reflected an economy that did not grow quite as fast in real terms during the 1Q2002 through 1Q2005 period as was originally reported. Most of the reduction in growth came as a result of inflation during the period that was higher than originally reported.
* Of the 13 quarters comprising the revision period, real GDP was revised downward in 10 of them, revised upward in one of them, and left unchanged in two of them. (See Tables 1 and 2 at the conclusion of the text.)
* Of the 13 quarters comprising the revision period, inflation as measured by the implicit price deflators for both overall GDP and for personal consumption expenditures was revised higher in 10 of them, lower in two of them, and left unchanged in one of them. (See Table 2 at the conclusion of the text.)
* After revision, real GDP for 2005's first quarter stood at $10999.3 billion. This compares with an originally reported figure of $11096.2 billion, for a reduction in terminal real GDP of $96.9 billion or almost 0.9%.
Nothing in the benchmark revisions dispell my warning of many months ago, to wit: At least a whiff of "stagflation" is returning to these numbers. And here, it is important to lay out the critical difference between relatives and absolutes.
Many on Wall Street would have you believe that stagflation is a phenomenon only present with high inflation rates, which is not accurate. There are three reasons I can quickly think of that might account for this distortion.
(1) Perhaps many of today's very bright but very young and inexperienced analysts simply were not taught certain relationships during their formal education process.
(2) Stagflation of the past often was accompanied by very high inflation rates. For instance, the inflation accompanying the so-called "Carter Malaise" period of the late 1970s was among the highest in the nation's history, with the reported CPI and PPI rates well into double digits.
(3) Stagflation does not denote a positive environment. Therefore, inherently, it is not something Street bulls would want to talk about. So, since reported inflation rates of the last few years have been low, if you associate stagflation with high inflation rates, you automatically have found a way either to avoid or to spin the subject.
I suspect that number three has a good deal of merit. But as to the way the phenomenon works in practice, high inflation rates are definitely not necessary to experience stagflation. Instead, it is present when inflation becomes a relatively large and growing portion of nominal or total growth.
For instance, if nominal GDP were growing at a 12% rate and 9%, or 75% of the total, was accounted for by inflation, thus, 3% or only 25% of the total accounted for by real growth, no one would deny the existence of stagflation. Suppose, though, that nominal GDP was growing at a 4% rate and 3%, or the same 75% of the total, was accounted for by inflation, therefore, 1% or the same 25% of the total accounted for by real growth. That, too, is stagflation.
If the numbers and their relationship get to a point where even the bulls cannot avoid acknowledging stagflation, don't rule out the emergence of a new body of economic thought that says, "Who cares, the economy is growing at a 5% or 6% rate, so what if a lot of it is inflation driven!"
Problem is, stagflationary environments simply are not healthy ones. History clearly shows that they create stress and distortions that are, at best, injurious to the economy in both macro and micro terms.
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Table 1.
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REAL GROSS DOMESTIC PRODUCT (SEASONALLY
ADJUSTED ANNUAL RATES, 2000 CHAINED DOLLARS)
--------------------------------------------
Year Q1 Q2 Q3 Q4
----------------------------------------
2005 New 3.8% 3.4% -- --
Old 3.8% NA -- --
----------------------------------------
2004 New 4.3% 3.5% 4.0% 3.3%
Old 4.5% 3.3% 4.0% 3.8%
----------------------------------------
2003 New 1.7% 3.7% 7.2% 3.6%
Old 1.9% 4.1% 7.4% 4.2%
----------------------------------------
2002 New 2.7% 2.2% 2.4% 0.2%
Old 3.4% 2.4% 2.6% 0.7%
----------------------------------------
2001 -0.5% 1.2% -1.4% 1.6%
2000 1.0% 6.4% -0.5% 2.1%
1999 3.4% 3.4% 4.7% 7.3%
1998 4.5% 2.7% 4.7% 6.2%
-----------------------------------------
New = revised; Old = prior
--------------------------------------
MEMO ITEM: Annual change in real GDP
before and after the "comprehensive
revision" published by the Commerce
Department on 12/10/03.
--------------------------------------
1929-2002 1959-1992 1992-2002
---------------------------------
After 3.4% 3.4% 3.2%
Before 3.4% 3.4% 3.2%
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Table 2.
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7/29/05 BENCHMARK REVISIONS TO
IMPLICIT PRICE DEFLATORS FOR GDP
AND FOR GROSS DOMESTIC PURCHASES
------------------------------------------------
Year Q1 Q2 Q3 Q4
------------------------------------------------
2005
New GDP Def. 3.0% 2.4% -- --
Old GDP Def. 2.9% NA -- --
-------------------------------------------
New PCE Def. 2.9% 3.3% -- --
Old PCE Def. 2.6% NA -- --
================================================
2004
New GDP Def. 3.7% 3.9% 1.3% 2.7%
Old GDP Def. 2.7% 3.2% 1.4% 2.3%
-------------------------------------------
New PCE Def. 4.3% 4.1% 1.9% 3.2%
Old PCE Def. 3.4% 3.5% 2.0% 2.9%
================================================
2003
New GDP Def. 3.1% 1.1% 1.9% 1.8%
Old GDP Def. 2.9% 1.1% 1.3% 1.4%
-------------------------------------------
New PCE Def. 4.1% 0.4% 2.1% 1.6%
Old PCE Def. 3.9% 0.4% 1.6% 1.2%
------------------------------------------------
2002
New GDP Def. 1.5% 1.4% 1.5% 2.2%
Old GDP Def. 1.0% 1.8% 1.3% 2.0%
-------------------------------------------
New PCE Def. 1.3% 2.4% 1.6% 2.2%
Old PCE Def. 0.8% 2.8% 1.4% 1.9%
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Table 3.
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NOMINAL AND REAL GROSS DOMESTIC PRODUCT
(SAAR, 2000 Chained Dollars); RATIO OF REAL
TO NOMINAL; IMPLICIT PRICE DEFLATORS FOR
GDP AND FOR GROSS DOMESTIC PURCHASES
(Incorporates Benchmark Revisions of 7/29/05)
------------------------------------------------
Year Q1 Q2 Q3 Q4
------------------------------------------------
2005 Nominal 7.0% 5.9% -- --
Real 3.8% 3.4% -- --
R/N 0.54 0.58 -- --
===========================================
GDP Def. 3.0% 2.4% -- --
PCE Def. 2.9% 3.3% -- --
------------------------------------------------
2004 Nominal 8.1% 7.5% 5.3% 6.1%
Real 4.3% 3.5% 4.0% 3.3%
R/N 0.53 0.47 0.75 0.54
===========================================
GDP Def. 3.7% 3.9% 1.3% 2.7%
PCE Def. 4.3% 4.1% 1.9% 3.2%
------------------------------------------------
2003 Nominal 4.8% 4.8% 9.3% 5.5%
Real 1.7% 3.7% 7.2% 3.6%
R/N 0.35 0.77 0.77 0.65
===========================================
GDP Def. 3.1% 1.1% 1.9% 1.8%
PCE Def. 4.1% 0.4% 2.1% 1.6%
------------------------------------------------
2002 Nominal 4.3% 3.7% 3.9% 2.4%
Real 2.7% 2.2% 2.4% 0.2%
R/N 0.63 0.59 0.62 0.08
===========================================
GDP Def. 1.5% 1.4% 1.5% 2.2%
PCE Def. 1.3% 2.4% 1.6% 2.2%
------------------------------------------------
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