1/30/13 – Bad Is Good

So, gross domestic product—that is, the U.S. economy—declined a bit (by 0.1 percent, to be exact) for the fourth quarter of last year. Is this it? Is a recession starting? What about all the good news I’ve been discussing? Aaaaaaaaaaaah!!!

Okay, I feel better now. In fact, while no one wants to see a decline in GDP, if we have to have one, this is exactly how we want it to happen.

Let’s look at the underlying data:

• Consumer spending, which represents about two-thirds of the economy, was up by 2.2 percent, accelerating from the previous quarter’s figure of 1.6 percent. Not only is a major part of the economy continuing to improve, it’s doing so at a faster pace, despite Hurricane Sandy and the fiscal cliff. Pretty encouraging.
• Next, one of the missing pieces in this recovery has been business investment, which popped by 8.4 percent, more than reversing the 1.8-percent decline in the third quarter. Again, this reversal came in the face of the fiscal cliff and, if it heralds a sustained return in business investment, will provide the last piece of the recovery.
• Residential investment popped by more than 15 percent, continuing the housing recovery.

Each of these components is very positive news. So what went wrong?

Three things: inventories, net exports, and a strange drop in defense spending. Inventories are expected to be a one-time adjustment, knocking about 1.3 percent off of GDP, while the net export figure is probably a longer-term drag, with imports continuing to exceed exports as the U.S. economy recovers. Both of these were somewhat expected, partially reversing a very strong third quarter.

The big mystery here is a 15-percent drop in government spending, driven by a 22-percent drop in defense spending, which knocked another 1.3 percent off of GDP. This drop hasn’t shown up in Treasury statements and is not consistent with defense-industry revenue figures, so no one knows yet where it came from. Best guess at this point is that it has something to do with accounting inconsistencies introduced by the fiscal cliff and pending sequester. Again, this should be a one-time adjustment and may well end up being revised away.

Together, these three factors knocked 2.9 percent off of growth in the quarter, after adding 1.9 percent in the third quarter. Other negative factors included warm weather, which, by reducing spending on utilities such as heat, actually reduced reported GDP by an estimated 0.5 percent.

Overall, the weak GDP figure for the fourth quarter appears to represent something of a mix of technical payback for a strong third quarter, one-time factors, and strange seasonal adjustments. Something is funny here, especially in the drop in government spending. This quarter does not represent a substantial weakening of the economy or a reversal of the recovery.

For 2012 as a whole, GDP grew 2.2 percent, up from 1.8 percent in 2011. The recovery, while slow, continues to strengthen despite the occasional statistical blip, and this should not be the start of a new recession.

That said, growth in the first quarter will face its own challenges, primarily the tax increases that are now showing up in the form of reduced take-home pay. Consumer confidence surveys have already taken a hit as a result of this. Other confidence-reducing events pending are the debt ceiling negotiations, the spending sequester, and the expiration of government spending.

We’re not out of the woods yet, but the details of the GDP report are actually much more encouraging than the headline number would suggest, especially on the consumer spending and business investment side. The recovery continues, for the moment.