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Wednesday, January 30, 2008

Q4 GDP - Better Than It Sounds

I'm sorry if you are seeking dark gloomy news, but I don't think Q4's headline 0.6% increase in GDP is bad news.

I have tried to explain several times that high inflation rates can mask a recession for a while. BEA tries to compensate for them, but IMO they don't do a very good job. Anyway, Q3's GDP, which is reported at 4.9%, was increased by a very low government economist calculated inflation rate, and also increased by a big build in private inventories. The reason why Q4's GDP looks so low is that inflation reality caught up a bit in the government numbers, and that private inventories were sold off.

It is true that the economy continues on its long slow decline, and I also believe that the rate of decline is accelerating. But it isn't accelerating hugely - really, all my data tells me it isn't. And here's some other data to support my view - ADP reports a January increase in employment of 130,000, which is quite good. ADP uses their payroll data to generate this number.

If you want to look at the underlying trends in the economy, gross private domestic investment will tell you the most, especially if you adjust that for the increase or decrease in non-farm private inventory (PI). Looking at Table 3 "real" figures, this has been the recent trend (and remember that the Q4 data will be revised):
Q4 2006: 1856.2, PI: 13.6, net 1842.6
Q1 2007: 1816.9, PI: -5.8, net 1822.7, QoQ -19.9
Q2 2007: 1837.4, PI: 1.3, net 1836.1, QoQ +13.4
Q3 2007: 1859.9, PI: 26.0, net 1833.9, QoQ -2.2
Q4 2007: 1810.5, PI: -6.9, net 1817.4, QoQ -16.5, YoY -1.4
Gross private domestic investment is basically split into two categories - change in private inventories and fixed investment. Fixed investment is compounded from residential and nonresidential, and nonresidential is compounded from structures, info equipment, industrial equipment, transportation equipment, and other equipment. Over the course of 2007, the trends in transportation and other equipment were negative, but there isn't any indication that those have abruptly worsened and the decline may be moderating. The trend change and the concern is that in Q4 industrial equipment investment fell off. When the weaker dollar kicks in, we hope to see that category start growing again.

In general, gross private domestic investment would only fall on an annual basis during recessions, and in 2007 it did. See Table 7 to illustrate. The difference between a mid-cycle slowdown and a recession is that gross private domestic investment declines during a recession whereas it just slows during a low growth period in the economy. Actually, the declines in gross private domestic investment drive the economy, jobs, and therefore consumer spending. After 1991, there have been only three years in which gross private domestic investment was negative, and those years were 2001(-7.9%), 2002(-2.6%) and 2007(-4.6%). That is what I mean when I write that by classic standards, we entered recession in 2007.

Another marker of recession periods is that government spending becomes a relatively bigger contributor to economic growth. 2007 was the third year in which government spending increased as a relative contributor to GDP. We seem to be in a very slowly developing recession which has inexorable qualities, and indeed, if you look at producer price increases compared to end sale increases, it is clear that price sensitivity is preventing costs from being passed along, which is another marker of recession.

I know that many are dreadfully upset by the Fed's recent interest rate cuts, but honestly, they should have begun them earlier - way earlier. The Fed is going to have to go very low now, because the Fed waited until too late and the effect of declining gross private domestic investment is likely to be amplified by the real and growing credit crunch.

In 2008, securitizations for bad CC and auto debt are going to start busting along with commercial mortgages, bad commercial debt and of course the continued weakness in residential mortgages. It is not a pretty picture. We cannot expect credit to improve for some time.

However, the encouraging thing about Q4 2007 is that it doesn't show a sharp break to a faster decline, although industrial equipment is discouraging. In about another 3 weeks rail data will tell us where we really are. There's a limit to how low the Fed can go with interest rates in this environment. If it goes too low, rates will go negative (below real inflation rates), which will have the effect of withdrawing money from investment. The Fed cannot risk that, because real negative rates at this juncture would cause a depression or something close to it. So the Fed is walking a fine line here.


Comments:
M.O.M.,

I agree. Q4 GDP was not that bad. Also, Q3 GDP was not that good.

From what I can see, the trend is decidedly negative though.

Its just hard for me to believe that a massive boom and bust in housing will not lead to a consumer led recession. We'll know soon.
 
Oh, we're in a recession right now.

The credit crunch would cause a recession within 8 months even if everything else were growing, and it wasn't.

The question for the Fed is how much they can offset of this trend in order to create a bump up in the production sector in 2008. Unfortunately, it was MEW that was offsetting steadily worsening fundamental conditions for consumer credit, and the MEW train for consumer discretionary spending has run off the tracks. Now it busts.
 
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