Is GDP Inflated?
04/30/08
The U.S. economy (allegedly) expanded at an annual rate of 0.6% during the first quarter of 2008. Economists had expected 0.5% and many stock market participants even expected a negative number. The report showed few surprises. The composition of growth in consumer spending showed a 3.4% increase in spending on services. This constituted the best increase in five quarters and offsets the 6.1% decline in spending on durable goods. Spending on services usually shows a direct impact on employment and therefore this part of the report was good although the overall number was weak. Not only was the "Real GDP" number weak, according to some critics, it was entirely misleading and should have been negative. To be sure, "Real GDP" sounds very much like "True GDP" (as in "the one and only true GDP") but that is not what the Bureau of Economic Analysis had in mind when they coined it "Real GDP". What they meant to convey was that there is "Nominal GDP", which after it gets adjusted for inflation, becomes "Real GDP". It is this process of adjusting for inflation that is flawed, according to the critics. Let�s look at the numbers. Nominal GDP grew in the last quarter at an annualized rate of 3.2%. We deduct the assumed inflation rate of 2.6% and you end up with an estimate of 0.6% "Real GDP" growth. Critics content that the inflation adjustment of 2.6% is not realistic and that "true inflation" is much higher. The Consumer Price Index for example calculates annualized inflation for March at around 4.0% (down from 4.1% in February and 4.4% in January). Taking the CPI as inflation adjustment, we would end up with "Real GDP" of -0.8%. The inflation estimate that has been preferred by the Fed for a long time is called the "Personal Consumption Expenditures" (PCE) Index. This index is released along with the GDP report and shows inflation to have run at around 3.4% in the first quarter of 2008. The resulting "Real GDP" thus would come out to be -0.2%. So which one is it? Are all the conspirationists right who claim that the government cheats? Of course not! It is just very difficult to provide a representative picture of overall inflation, that�s all. Let�s look at some GDP related pictures.
The first chart has the title "Real GDP" and is the official tally of the nations GDP growth as published by the Bureau of Economic Analysis. The second chart represents the official inflation rate that is applied to the GDP report. This second chart in particular is confusing me because the inflation estimates for 2007 range from 4% in the first quarter to 1% in the third quarter. Now we all know that inflation is a trending animal and does not jump around like that. What were they thinking? I sure don�t know but I grant them that they were thinking something. As much as we would like attribute malicious data mining to certain government bureaucracies, whatever they do, they usually do it consistently. Therefore I must assume that the implicit price deflator jumps around like a bunny rabbit despite (and not because) of the consistent application of certain government assumptions. Although the way real GDP numbers are computed may not be satisfying to you and me, as long we have no better alternative, we probably will have to live with certain imperfect methods of estimating a very complex set of data. Just to prove this point, I experimented with different adjustments for inflation. I used the Nominal GDP number and adjusted it for the CPI Index and for the Fed�s preferred Personal Consumption Expenditures (PCE) Index. For the CPI adjustment I used the CPI number that was published for the first month of the quarter, for which the GDP was calculated. The resulting chart may be somewhat confusing in its detail but one thing immediately jumps out: All different adjustments might affect the absolute level of the GDP growth, but they all get the general direction right. If you compare the blue and green lines, they move very closely together and, surprise, they also track very closely with the Real GDP line in the first chart above. Let�s take the 1991 recession for example. Real GDP went to a negative 3% in the fourth quarter of 1991. The CPI adjusted GDP number (blue line) went to minus 6.4% in that same quarter and the PCE adjusted GDP number went to minus 5.2%. Critics might raise serious concerns about a discrepancy of absolute levels (minus 6.4% for CPI adjusted GDP versus minus 3.0% for Real GDP) but the fact is that all versions reached their peaks and valleys at the same time. I am not taking these discrepancies lightly, but I fail to see any viable alternative, so I am content to use what is given to me. As long as the direction is correct, I can live with divergences.
If, however, you are not content with direction (remember that Wall Street loves the second derivative) and can not live with data sets that differ at extremes by over 100%, then you can always use surveys. The last chart today shows the so called "Anxious Index". I quote from the website of the Federal Reserve of Philadelphia:
"In an article on September 1, 2002, New York Times reporter David Leonhardt used the term anxious index to refer to the probability of a decline in real GDP, as reported in the Survey of Professional Forecasters. The survey asks panelists to estimate the probability that real GDP will decline in the quarter in which the survey is taken and in each of the following four quarters. The anxious index is the probability of a decline in real GDP in the quarter after a survey is taken. For example, in the survey taken in the first quarter of 2008, the anxious index is 42.9 percent, which means that forecasters believe there is a 42.9 percent chance that real GDP will decline in the second quarter of 2008."
The index shows a surprising accuracy. It spikes right into the beginning of a recession. It is currently spiking and whether GDP growth last quarter was 0.00% or slightly negative or positive does not really matter. What matters is that the economy is slowing and that the Anxious Index is spiking. Whether 2008 will meet the official score keepers' technical definition of a recession or not is not as important as getting the direction right. Stock investors therefore have to be cognizant of the fact that the economy has slowed and that the cycle therefore favors early cyclical stocks such as banks and brokers. Late cyclical shares, on the other hand, such as heavy industry and commodity stocks, are to be avoided, says the conventional wisdom on Wall Street. We should not argue with these truisms. Let us just keep in mind that every business cycle has its own character and cookie cutter solutions are therefore dangerous. Nevertheless, it seems that the anticipated dollar weakness lead to a marked correction among all raw materials last week. Whether this will prove the beginning of the end for the commodity sector remains to be seen. The resulting out performance of financial shares over late cyclical shares, however, was very obvious throughout this past week. Stay with it, it might become a trend.
Hermann Vohs
Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.
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