GDP Growth in the Fourth Quarter of 2011: Not a Very Good Report

BEA release of 1/27/12 2011 Q3% growth 2011 Q4% growth Contribution to GDP growth in 2011 Q4
Total GDP 1.8 2.8
A.  Personal Consumption Expenditure 1.7 2.0 1.45
B.  Gross Private Investment 1.3 20.0 2.35
   1.  Non-Residential Fixed Investment 15.7 1.7 0.18
   2.  Residential Fixed Investment 1.3 10.9 0.23
   3.  Change in Private Inventories nm* nm* 1.94
C.  Net Exports nm* nm* -0.11
D.  Government Consumption and Investment -0.1 -4.6 -0.93
   1.  Federal Government 2.1 -7.3 -0.62
   2.  State and Local Government -1.6 -2.6 -0.32
Memo:  Final Sales 3.2 0.8 0.82
        nm* = not meaningful

The Bureau of Economic Analysis of the US Department of Commerce released this morning its first estimate of GDP growth in the fourth quarter of 2011.  The headline figure of 2.8% growth of total GDP might look reasonably good (actually, it is less than is needed in the on-going recovery, with unemployment still so high; it would be a reasonable growth rate if the US were already at full employment).  But the underlying details that led to this overall growth are worrisome.

As has been noted before in this blog, the short run dynamics of the quarter to quarter change in GDP is heavily influenced by what is happening to the change in private inventories.  Keep in mind that it is the change in the change in private inventories that is one component of the change in GDP in any given quarter.  In the third (and final) revision to the estimated GDP accounts for the third quarter of 2011, the change in private inventories was essentially zero.  This was down from a positive growth in inventories in the second quarter, and hence the contribution to the change in GDP in the third quarter was negative.  I noted then that there was a good chance that inventories would return to some positive growth in the fourth quarter, and hence spur the GDP growth figure for the quarter.  And this they did.  According to this first estimate for the fourth quarter, 1.94 percentage points of the 2.76% growth in total GDP (rounded to 2.8% in the reports), was due to this bounce back of  private inventories.  That is, 70% of the growth (1.94 / 2.76) was due to the change in the change in private inventories.

Leaving out this change in the change of private inventories, the growth of final sales was just 0.8%.  This is substantially down from the 3.2% figure for the third quarter.  This is a disappointment.  If final sales do not grow by more than that now, in the first quarter of 2012, one can easily see private inventories being cut back, and overall GDP growth would then be negative.  If that happens for two quarters, one will have met the standard definition of a new recession.  Not good in an election year (or any year for that matter).

There were two main reasons why final sales grew so much more slowly in the fourth quarter of 2011 than in the third quarter.  One was that non-residential fixed private investment grew by only 1.7% in the fourth quarter, sharply down from the 15.7% annualized growth in the third quarter.  It was still positive growth, and hence contributed to overall GDP growth, but only by 0.18 percentage points vs. a contribution of 1.49 percentage points in the third quarter.

Offsetting this a bit was the encouraging figure that residential fixed investment (mainly housing construction) grew at a 10.9% rate in the fourth quarter.  This was the fastest growth for such investment in a year and a half.  But this quarter to quarter figure can bounce around substantially.  More importantly for the contribution to overall GDP growth, residential fixed investment has declined by so much (since 2006), that it is now a relatively small share of GDP.  It would need to triple (i.e. grow by 200%) to get back to where it was before.  And non-residential fixed investment is 4.6 times as large, so what is happening to non-residential fixed investment is much more important.

But the most important reason for the disappointing growth in fourth quarter GDP was an absolute decline in government expenditure.  Total government consumption and investment expenditure fell by 4.6% in the fourth quarter, with federal government expenditure falling by a sharp 7.3% and state and local government expenditure falling by 2.6%.  For 2011 as a whole, federal expenditure fell by 2.0%, while state and local expenditure fell by 2.3%.

With this drag caused by falling government expenditures, it should not be surprising that GDP growth was so weak, held up mainly by inventory accumulation.  And if inventories now revert (over time, the quarter to quarter changes average close to zero), the US could fall back into a recession.  Yet many Republicans and especially the Tea Party supporters continue to claim that the way to get strong growth is for government to contract.  They claim that such contractionary policies will be expansionary.  Yet one sees no evidence of this in the new figures.  If it were not for the accumulation of private inventories (items produced but then not sold), GDP growth in the fourth quarter of 2011 would have been extremely weak.  Contractionary policies are contractionary.

But there was good news on the inflation front, assuming one believes lower inflation is always good.  As part of the GDP accounts, the BEA also estimates the price deflators for the various GDP components (so as to go from the nominal measures to real ones, so one can then get real growth rates and changes), and in particular the price deflator for Personal Consumption Expenditures (PCE).  This PCE deflator is favored by many, including reportedly Alan Greenspan (although he in fact focused more on the core PCE deflator, which excludes food and energy prices), as the best estimate of what is happening to US inflation.  The PCE deflator rose by 1.8% in 2010 as a whole, and then at an (annualized) rate of 3.9% in the first quarter of 2011.

Conservative economists, such as John Taylor of Stanford and Allan Meltzer of Carnegie Mellon, as well as Republican politicians such as Congressman Paul Ryan and others, had complained of the Fed’s aggressive policies to spur the economy, and asserted that they would lead to high inflation in the US (see, for example, here and here).  John Taylor often invoked the hyperinflation in Zimbabwe as a warning of what could happen if monetary policy was not brought under control (see, for example, here).  The rise in the PCE deflator in early 2011 was promoted as evidence of inflation starting to rise.  Keynesian economists, such as Paul Krugman, argued inflation was not a concern, with the economy in a liquidity trap and high unemployment keeping down wages so that unit labor costs were falling or flat.  They argued that the rise in observed inflation in early 2011 was due to changes in volatile commodity prices such as oil, and that such changes are rarely sustained.

What has happened since early 2011 clearly supports Krugman and the Keynesians.  After  rising at a 3.9% rate in the first quarter of 2011, the PCE deflator rose at a 3.3% rate in the second quarter and a 2.3% rate in the third quarter.  And the newly released figures for the fourth quarter indicate an estimate of just a 0.7% rise in the fourth quarter.  While the fourth quarter figures are subject to change, the trend is clearly down, with an inflation rate that is indeed arguably now too low.  Such a low inflation rate makes it more difficult for the economy to adjust (as relative prices are then more difficult to adjust), plus the very low rate increases the risk of the economy declining into price deflation, where it can be very difficult to emerge (as Japan faced in the 1990s).

One final point:  One should not put too much weight on any figures on the economy for just one quarter.  Quarter to quarter figures can bounce around a lot.  And the figures released today are simply the first estimates of what the economy was doing in the last quarter of 2011.  Over the next two months, these initial estimates will be revised twice, as is always done.  Sometimes the revisions can be significant.

Still, some of the initial estimates are of concern, and should the trends continue into 2012, the economy will be in trouble.