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Summary
Last Friday, Wall Street suffered instashock, when the US Commerce Department reported that fourth-quarter real gross domestic product only had expanded at a 1.1% annual rate. Colleague, John Williams, and I were shocked, too, but for considerably different reasons!
Introduction
John and I spend much of our respective analytical time criticizing the accuracy -- occasionally, even the outright honesty -- of the government's economic numbers. Understated inflation and overstated employment growth are a couple areas that are among our favorite targets. But overstated economic growth gets a good deal of attention, as well. After all, the automatic consequence of consistently understating inflation is to consistently overstate the economy's real growth.
So when along came a GDP report that appeared to us to portray more accurately the economy's actual condition, it was at least a mild shock. On the other hand, Wall Street's shock was driven by a materially different reason and motivation. If you are out heavily promoting a "Goldilocks" environment, the last thing you need is a report showing the worst economic growth in three years. In fact, growth that actually came in negative, if you place analytical importance on real final sales. (We do!)
A few highlights:
* The Commerce Department's first ("advance") estimate of fourth-quarter 2005 gross domestic product indicated real growth during the period at a 1.1% annual rate, versus a 4.1% rate during last year's September quarter.
* During last year's final quarter, real final sales (GDP net of inventory change) actually contracted at a 0.3% annual rate.
* Measured in nominal (pre-inflation) terms, fourth-quarter 2005 GDP rose at a 4.2% rate, down sharply from the 7.6% rate of nominal growth during last year's third quarter.
* Measured on a 4Q2005-over-4Q2004 basis, real GDP in 2005 grew by 3.1%.
* The report also showed a highly "stagflationary" mix in the numbers. Real GDP was a mere 26% of nominal GDP.
* The consensus estimate for real fourth-quarter growth had anticipated something around a 2.8% annual rate, far above the 1.1% rate actually reported.
This launched Wall Street into a mode of maximum spin, and at warp speed, too! The defense mechanism immediately employed by the Street (and others) was to impugn the data's accuracy and sensibility, in the process, assuring everyone the data would be revised to better readings in February, when Commerce publishes its next estimates.
An overall upward revision very well may occur, but surely not to a level that will make the Street (and others) overly ebullient. After all, were Commerce to revise last week's number up by 100% (terribly unlikely), the 2.2% real GDP growth that would result would still be well below the roughly 2.8% the consensus forecast was envisioning.
We believe last Friday's numbers, as rendered, were not as outlandish as some would have people believe. The balance of this missive will provide some of the reasoning.
___
Onward
The balance of this missive contains a good deal of numbers and discussion of them. Early on, however, let me point out that the initial or "advance" report on gross domestic product is just that. When the numbers came out last week, the Commerce Department was still in arrears in reporting and even in collecting some critical data. The December trade figures come readily to mind, since the trade deficit played such an important role in last week's lousy GDP performance. (The December trade report is due out next Friday, 2/10.)
Also early on, I want in the strongest way to encourage people who are not familiar with John Williams' work to change that, and quickly. Simply go to John Williams' Shadow Government Statistics and you will find ample explanation of why it is easy today to be so skeptical if not outright cynical about at least the accuracy -- at times, the honesty, too -- of most of the key economic data coming from Washington. This said, you can understand why it borders on amusing that I'm writing a missive claiming there was at least a modicum of sensibility in last week's gross domestic product report from the Commerce Department.
In addition to examining numbers, though, this missive also is a little about the Wall Street (and Washington) culture, which I will address and get out of the way now.
It Hits the Fan!
The GDP numbers were out only momentarily last Friday, or that's the way it seemed, when spin the magnitude of which you rarely witness even from Wall Street was in full swing. Simply look at how the year-to-date craziness in the stock market is being justified, which I think represents whistling past the graveyard at its very best, and you know that the Street is simply of no mind at the moment to tolerate any bad news -- period!
If at that moment I had been looking for a specific, real-time example of just how far 'round the bend many on Wall Street or those who do its bidding really had gone, I could not have found one much better than the example of spin run amok that materialized. A financial commentator on a major NYC radio station, "reporting" on the GDP release, opined that the report simply appeared too weak to be accurate. Therefore, it surely would be revised upward. Which instantly gave rise to a rhetorical mental question of how come when government releases come along that appear blatantly (and purposely?) to overstate GDP or employment growth, or to understate by horrendous proportions inflation, they are never accorded a similar critique?
But more surrealism was quickly to follow. Soon, an e-mail showed up in my in-box from none other than -- Treasury Secretary John Snow. In part, "JS-3088" read:
"The advanced estimate of fourth quarter 2005 GDP released this morning is inconsistent with the underlying strength of the U.S. economy.
"I would not read too much into today's numbers. They are somewhat anomalous, reflecting some special factors. They are not consistent with other data on the U.S. economy which paint a picture of good growth... The American economy is on a good course and I am very confident. I am optimistic about the first quarter and the year ahead and am confident that we will see strong growth for the year.
"...We will look forward to revisions of the preliminary estimates in the coming months. Economic fundamentals point to continued strong economic performance in the United States in 2006. The U.S. economy is performing well."
(NOTE: Mr. Snow's entire communique can be accessed at "Statement by Treasury Secretary John Snow on the Release of Preliminary Estimates of Fourth Quarter 2005 GDP.")
I found this of major interest since: (1) It got out so quickly. Did Secretary Snow have an advance copy of the release? (2) Secretary of Commerce Carlos Gutierrez and Secretary of Treasury John Snow are both Executive Branch officials, ostensibly on the same team. Wasn't this kind of like Treasury ratting out Commerce? Anyway...
A "Sensibility or Two"
OK, it's time for some general numbers crunching. The highlights here are examined in more depth later. In the sensible category, there are three major items of import in the GDP report. First is inventories.
* Last week's report showed a $25.7 billion build in inventories during last year's fourth quarter, representing a $39.0 billion swing from the third quarter. In turn, this was equal to about 125% of total GDP growth between the third and fourth quarters. The key reason this is a sensible number, at least within a political context, is because had it been only about $9 billion less, 4Q2005 real GDP would have come in negative. (This syndrome is discussed in greater detail later.)
* Personal consumption expenditures (which are pretty much what they sound like they are) are equal to almost 71% of real GDP. So unless there is respectable growth here, it is difficult for the other 29% of GDP to pick up the slack.
Why isn't it sensible, considering energy prices, etc. to think consumers were very cautious during last year's final quarter, particularly when you sift through Christmas sales? But here's the clincher of sensibility, delivered by a different agency way back on January 9th.
On 1/9, the Federal Reserve reported that consumer debt fell in November, which made two consecutive months of decline. In turn, this was the first time this had occurred in more than 13 years. Since personal consumption has been driven heavily by borrowing, why isn't it sensible to think that if consumers weren't borrowing in the fourth quarter, consumption would suffer?
The December figure is due out next Tuesday (2/7). However, even if with reasonably strong borrowing in December, as well as upward revisions to prior data, it would not likely pull up personal consumption expenditures in a huge way in the revised GDP report.
And there's a another factor to consider with regard to consumer caution. This is the continuing decline in real purchasing power, and that is even if you accept that nominal wages are being deflated by a Consumer Price Index that is as tame as the Labor Department says it is. The following table tells the squeeze tale, and you might want to have a look at the graph on John Williams' home page regarding the CPI.
Dec./Dec. Change
--------------------
Measure 2005 2004 2003
---------------------------------------------
Employment Cost Index* 2.6% 2.4% 2.9%
Average Hourly Earnings 3.1% 2.6% 1.7%
Consumer Price Index 3.4% 3.4% 1.9%
---------------------------------------------
*Wage and salary component.
---------------------------------------------
* The third and final area is the trade deficit (or, in GDP parlance, "net exports"), where each dollar of deficit costs a dollar of GDP. In other words, there is a one-for-one offset.
The total third-quarter trade subtraction from GDP was $617.5 billion. In the report for 4Q2005, this rose to minus $650.3 billion, an increased subtraction of a whopping $32.8 billion, although one month of trade -- December -- was unreported. (December's trade report is due for release next Friday, 2/10). Nevertheless, unless revised otherwise, two of the largest monthly trade deficits in history occurred in October and November. This resulted in a monthly average of reported data for the fourth-quarter of $66.18 billion, versus the $60.93 billion monthly average for the September quarter.
Unfortunately, because of various adjustments, the net monthly figures do not flow through to the GDP report intact. Nevertheless, it is reasonable to think that even if the fourth quarter's minus $650.3 billion is revised downward, it will be no where near enough to come even close to wiping out the $32.8 billion difference between the third and fourth quarters.
A Broader Examination of the
"Advance" Fourth-Quarter Numbers
* Last week, the Commerce Department reported that real gross domestic product grew at a 1.1% annual rate during last year's the fourth quarter, much slower than the 4.1% rate of growth reported for the September quarter. Remember, though, that the final estimate of third-quarter growth had been revised from 4.3% to the final 4.1%, suggesting the possibility activity was cooling as the September quarter was drawing to a close.
* The advance estimate of fourth-quarter real GDP versus the final estimate of third-quarter real GDP shows an increase of $31.2 billion, or about 0.279%. Add one, then raise the result to the fourth power, and you get the rounded annual rate of change of 1.1%.
* The reported fourth-quarter result was far worse than a consensus forecast that was looking for something around 2.8% growth.
* Inventory build during the first quarter was reported at $25.7 billion, representing a positive swing of $39.0 billion from the third quarter. GDP accounting is such that inventory change is either an addition to or subtraction from gross domestic product. Therefore, the fourth-quarter change in inventories was equal to roughly 125% of the fourth quarter's total growth in real GDP.
* Although this phenomenon helped "top-line" GDP growth immensely, it resulted in negative growth of 0.3% for the quarter in real final sales. "Final sales" is the designation for GDP growth net of inventory change. In last year's third quarter, final sales grew at a positive and healthy 4.6% annual rate.
* Because of inventory characteristics in general, no less the difficulty associated with accurately accounting for them, many analysts (I among them) view real final sales as a better gauge of overall economic performance than the top-line measure of real GDP.
* In passing, I also point out that because of the difficulty of accurately accounting for inventories and therefore in challenging what the quarterly numbers really are, they represent a wonderful "plug" factor. The public at large doesn't understand much, even anything, about "final sales." Imagine, though, how horrifying it would have been last week had inventories not grown enough to create even a meager 1.1% top-line GDP growth, thereby giving rise to TV and newspaper headlines reading something like, "US Suffers Negative Economic Growth." Remember, too, that the classic definition of a recession is two consecutive quarters or negative real GDP growth. Thus, in the absence of enough inventory swing, the US might have had one-half a recession in place!
* Hurricanes Katrina and Rita made US landfall on August 29th and September 23rd, respectively. Thus, chronologically speaking, these storms' influence on fourth-quarter gross domestic product was probably material. But owing to massive aid distribution, insurance payments, etc. the impact was by no means monolithically negative. While it is virtually certain the storms subtracted something from fourth-quarter growth, the amount might not have been as large as some were opining last week, in an attempt to discredit the GDP number.
The following is from an earlier release from the Commerce Department that quantifies the region's overall economic importance.
"Louisiana’s gross state product is about 1.2 percent of U.S. GDP, but the state ranks first in the U.S. in terms of specialization in water transportation and third (behind Alaska and Wyoming) in terms of specialization in oil and gas extraction. While the New Orleans-Metairie-Kenner Metropolitan Statistical Area (MSA) only accounts for about 0.4 percent of U.S. personal income, the MSA accounts for over one-third of Louisiana’s personal income.
"Mississippi’s gross state product is about 0.7 percent of U.S. GDP. Together, the Gulfport-Biloxi and Pascagoula MSAs account for 15 percent of Mississippi’s personal income.
"Alabama’s gross state product is about 1.2 percent of U.S. GDP. The Mobile, Alabama MSA accounts for about 8 percent of Alabama’s personal income."
* The three-month period ended December 2005 was the 17th consecutive quarter of reported real GDP expansion.
* Per expectation, the "worse-than-expected" fourth-quarter result launched the immediate outcry from Tout TV and the other venues in the regular propaganda loop (as well as others) that is discussed earlier.
* While annualized real GDP is a huge number measured in the many trillions, relatively small changes from one quarter to the next have a sizable impact on annual rates of change, in one direction or the other. For instance, the $31.2 billion gain between the third and fourth quarters resulted in a change of 1.1%. Had the $31.2 billion been $77.6 billion, the rate of change would have come in around the expected 2.8%.
* Running again through the same exercise as above, it would take an upward revision of roughly $31 billion, to $62.2 billion, to double the reported 1.1% to a 2.2% rate. But looking at the composition of the already reported data, it is unlikely the Commerce Department will come up with another $31 billion when it releases the next estimate of fourth-quarter GDP, which is due out on 2/28.
Nominal (Pre-Inflation) Comparisons
* Versus 2005's third quarter, 4Q2005 nominal GDP rose $126.6 billion, or at an annual rate of 4.2%. The respective numbers: 4Q2005 = $12735.3; 3Q2005 = 12605.7 billion. The fourth-quarter rate was down substantially from the 7.6% rate achieved during the third quarter.
* Versus 2004's fourth quarter, 4Q2005 nominal GDP rose $740.1 billion, or 6.2%. The respective numbers: 4Q2005 = $12735.3 billion; 4Q2004 = $11995.2 billion.
Real (After-Inflation) Comparisons
* Versus 2005's third quarter, 4Q2005 real GDP rose $31.2 billion, or at an annual rate of 4.3%. The respective numbers: 4Q2005 = $11233.5 billion; 3Q2005 = $11202.3 billion. This versus a 4.1% rate during the third quarter, and against a consensus forecast of around 2.8%.
* Versus 2004's fourth quarter, 4Q2005 real GDP rose $336.4 billion or 3.1%. The respective numbers: 4Q2005 = $11233.5; 4Q2004 = $10897.1 billion.
"Advance" 4Q2005 Vs. "Final" 3Q2005 Comparisons
* Four of the six primary GDP categories added to real growth in the "advance" 4Q2005 versus "final" 3Q2005 GDP estimates. Two subtracted from it. The net result was an increase of $31.2 billion.
The categories adding to growth, ranked by their dollar contribution were:
(1) Inventory change (+$32.0 billion),
(2) Personal consumption expenditures (+$22.3 billion),
(3) Nonresidential fixed investment (capital
spending, +$9.0 billion),
(4) Residential fixed investment (housing, +$5.2
billion).
The categories subtracting from growth, ranked by their dollar impact were:
(1) Net exports (minus $32.8 billion), by virtue of a
widening in the trade deficit by that amount),
(2) Government spending (minus $11.9 billion). Spending
by state and local governments rose by $1.3
billion, offset by a $13.4 billion decline in
federal spending, $17.4 billion of which came
from a drop in defense spending.
The following table breaks out in greater detail many of the numbers discussed above.
----------------------------------------------------------
ADVANCE ESTIMATE OF FOURTH-QUARTER 2005
REAL GROSS DOMESTIC PRODUCT (Released
01/27 -- Billions of 2000 Chained Dollars
at Seasonally Adjusted Annual Rates)
----------------------------------------------------------
4Q2005 3Q2005 Change/ 3Q05F/
Advance Final Impact 2Q05F
--------------------------------
Real GDP 11233.5 11202.3 1.1% 4.1%
Inventory Change 25.7 -13.3 +$39.0 -$11.6
Real Final Sales 11205.0 11214.4 -0.3% 4.6%
----------------------------------------------------------
Components of GDP
-----------------
Personal Consumption 7930.2 7907.9 1.1% 4.1%
Nonres. Fixed Investment* 1314.2 1305.2 2.8% 8.4%
Resid. Fixed Investment 615.2 610.0 3.5% 7.3%
Net Exports -650.3 -617.5 -$32.8 -$3.3
Government Purchases* 1986.2 1998.1 -2.4% 2.9%
----------------------------------------------------------
<---- Price Indexes --->
Gross Domestic Product 3.0% 3.3% -- 3.3%
Gross Domestic Purchases 3.3% 4.2% -- 4.2%
----------------------------------------------------------
*MEMO ITEMS
-----------
Government Purchases
--------------------
Total 1986.2 1998.1 -2.4% 2.9%
State & Local 1249.8 1248.5 0.4% 0.2%
Federal 736.1 749.5 -7.0% 7.5%
National Defense 486.2 503.6 -13.1% 10.0%
Nonresidential
Fixed Investment
----------------
Total 1314.2 1305.2 2.8% 8.4%
Structures 254.5 254.1 0.6% 2.2%
Equipment & Software 1076.8 1067.5 3.5% 10.6%
Info. Processing
Equip. & Software 613.4 600.2 9.1% 11.1%
----------------------------------------------------------
MAJOR GDP COMPONENTS -- CHANGES BETWEEN
"ADVANCE" 4Q2005 AND "FINAL" 3Q2005 ESTIMATES
(Billions of 2000 Chained Dollars at
Seasonally Adjusted Annual Rates)
----------------------------------------------------------
4Q2005 3Q2005
Advance Final Change
-----------------------------
Real GDP 11233.5 11202.3 31.2
Inventory Change 25.7 -13.3 39.0
Real Final Sales 11205.0 11214.4 -9.4
------------------------------------------------------
Personal Consumption 7930.2 7907.9 22.3
Nones. Fixed Invest. 1314.2 1305.2 9.0
Resid. Fixed Invest. 615.2 610.0 5.2
Net Exports -650.3 -617.5 -32.8
Govt. Purchases 1986.2 1998.1 -11.9
----------------------------------------------------------
REAL GROSS DOMESTIC PRODUCT (SEASONALLY
ADJUSTED ANNUAL RATES, 2000 CHAINED DOLLARS)
--------------------------------------------
Year Q1 Q2 Q3 Q4
----------------------------------------
2005 3.8% 3.3% 4.1% 1.1%
2004 4.3% 3.5% 4.0% 3.3%
2003 1.7% 3.7% 7.2% 3.6%
2002 2.7% 2.2% 2.4% 0.2%
2001 -0.5% 1.2% -1.4% 1.6%
2000 1.0% 6.4% -0.5% 2.1%
1999 3.4% 3.4% 4.8% 7.3%
1998 4.5% 2.7% 4.7% 6.2%
-----------------------------------------
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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Real Vs. Nominal: The Whiff
of "Stagflation" Intensifies
* The key price indexes in last week's report for the fourth quarter came in lower than those reported for the third quarter. The 4Q2005 price index for gross domestic product was reported at 3.0% (down from the third quarter's 3.3%) and the 4Q2005 price index for gross domestic purchases was reported at 3.3% (versus 4.2% for the third quarter). The fourth-quarter numbers certainly did not nothing to mitigate concerns about "stagflation."
Here are how these key GDP price indexes have performed over the last 16 quarters (Q/Q change at annual rates):
------------------------------------------------------
Gross Domestic Product Gross Domestic Purchases
------------------------------------------------
1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q
---------------------- -----------------------
2005 3.1% 2.6% 3.3% 3.0% 2.9% 3.3% 4.2% 3.3%
2004 3.6% 3.9% 1.5% 2.7% 4.2% 4.1% 2.0% 3.2%
2003 3.1% 1.1% 1.8% 1.9% 4.1% 0.4% 2.0% 1.7%
2002 1.7% 1.5% 1.6% 2.2% 1.5% 2.5% 1.7% 2.2%
------------------------------------------------------
* On 7/29, the Commerce Department published benchmark GDP revisions from 2002 forward. Of the 13 quarters comprising the then-revision period, inflation as measured by these price indexes was revised: higher in 10 of them, lower in two of them, left unchanged in one of them.
* Nothing in those benchmark revisions or in the latest numbers have dispelled my warning of many months ago, to wit: At minimum, a whiff of "stagflation" was returning to the numbers. And in this regard, it remains 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. I can quickly think of three reasons 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 want to talk about. Thus, 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 much merit. But as to the way the phenomenon works in practice, high inflation rates are definitely not necessary to experience stagflation. Rather, it is present when inflation becomes a relatively large portion of nominal or total growth, and remains as such or continues to expand even more in proportion.
* Stagflationary environments simply are not healthy ones. History unambiguously shows that they create stress and distortions that are injurious to the economy in both macro and micro terms.
The following table breaks out the relationship between nominal and real gross domestic product over the last 16 quarters (looking at the things on the basis of quarter over prior quarter). Note how in 2005's fourth quarter the real-growth portion of total growth slipped to about 26%, meaning that approximately 76% was driven by higher prices.
----------------------------------------------------------
NOMINAL AND REAL GROSS DOMESTIC PRODUCT
(SAAR, 2000 Chained Dollars); RATIO OF REAL
TO NOMINAL; PRICE INDEXES FOR GROSS DOMESTIC
PRODUCT AND FOR GROSS DOMESTIC PURCHASES
(Incorporates Benchmark Revisions of 7/29/05)
----------------------------------------------------------
Year Q1 Q2 Q3 Q4
-----------------------------------------------------
2005 Nominal 7.0% 6.0% 7.6% 4.2%
Real 3.8% 3.3% 4.1% 1.1%
R/N 0.54 0.55 0.54 0.26
--------------------------------------------
Price {GDP 3.1% 2.6% 3.3% 3.0%
Indexes {GD Purch. 2.9% 3.3% 4.2% 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
-------------------------------------------
Price {GDP 3.6% 3.9% 1.5% 2.7%
Indexes {GD Purch. 4.2% 4.1% 2.0% 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
-------------------------------------------
Price {GDP 3.1% 1.1% 1.8% 1.9%
Indexes {GD Purch. 4.1% 0.4% 2.0% 1.7%
=====================================================
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
-------------------------------------------
Price {GDP 1.7% 1.5% 1.6% 2.2%
Indexes {GD Purch. 1.5% 2.5% 1.7% 2.2%
----------------------------------------------------------
The following table examines the same data as shown above, except it does so for an additional three years. Furthermore, the calculations are done on the basis of fourth quarter over fourth quarter, thus providing one method of a year-over-year measurement. The data clearly show the trend of the declining contribution of real growth to total growth over the last two years.
----------------------------------------------------------
GROSS DOMESTIC PRODUCT - 4TH QUARTER OVER 4TH QUARTER
----------------------------------------------------------
2005* 2004 2003 2002 2001 2000 1999 1998
----------------------------------------------
Nominal[1] 6.2% 6.8% 6.1% 3.6% 2.7% 4.6% 6.3% 5.7%
----------------------------------------------------------
Real[2] 3.1% 3.8% 4.0% 1.9% 0.2% 2.2% 4.7% 4.5%
----------------------------------------------------------
R/N 0.50 0.56 0.67 0.53 0.07 0.48 0.75 0.79
----------------------------------------------------------
*Calculated on "advance estimate" data. [1]Billions of
current dollars. [2]Billions of chained 2000 dollars.
----------------------------------------------------------
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