A Dismal^2 Q1 Final GDP Report

by Zach Bethune, Thomas Cooley and Peter Rupert

Final Revision to Q1 GDP: UGH!

Yesterday the BEA announced another large downward revision to first quarter GDP growth from -1.0% to -2.9%. The final estimate was primarily attributed to downward revisions in consumption (3.1% to 1.0%) and exports (-6.0% to -8.9%). In addition, there was a major hit to the late-2013 inventory overbuild and construction.



All of this, obviously, leaves the FOMC and the administration in a tough position. While many analysts recount weather-related setbacks and changes in depreciation allowances (such as I.R.C. 179), there is certainly real concern that the weakness is, well, weakness.  Before the downward revisions, the weak Q1 GDP figures were already on the Fed’s mind. From Janet Yellen’s congressional testimony on May 8 (emphasis added):

“Although real GDP growth is currently estimated to have paused in the first quarter of this year, I see that pause as mostly reflecting transitory factors, including the effects of the unusually cold and snowy winter weather. With the harsh winter behind us, many recent indicators suggest that a rebound in spending and production is already under way, putting the overall economy on track for solid growth in the current quarter. One cautionary note, though, is that readings on housing activity–a sector that has been recovering since 2011–have remained disappointing so far this year and will bear watching.”

Real private domestic investment, after having just reached its levels from December, 2007, has been stagnant of late.  Both nonresidential and residential investment are culprits, though both had upward revisions from -1.6% to -1.2% and -5.0% to -4.2%.  The numbers are nothing to cheer over, but there is also nothing in today’s report should change the Fed’s reading on the housing market from May.





More recently from Janet Yellen’s June 18th press conference (again emphasis added):

Although real GDP declined in the first quarter, this decline appears to have resulted mainly from transitory factors. Private domestic final demand—that is, spending by domestic households and businesses—continued to expand in the first quarter, and the limited set of indicators of spending and production in the second quarter have picked up. The Committee thus believes that economic activity is rebounding in the current quarter and will continue to expand at a moderate pace thereafter.

With yesterday’s large downward revisions to consumption, private domestic final demand is now estimated to have fallen in the first quarter, though more recent data are still in line with higher spending in the second quarter.

It’s not at all clear how much the revision will alter the Fed’s economic outlook or their stance on policy accommodation. The focus is still largely on improvements in the labor market, but a -2.9% Q1 growth rate is far from the FOMC’s latest central tendency projections for 2014 of 2.1%-2.3% growth. So what exactly does the growth rate of real GDP have to average over the next three quarters to be in line with the FOMC’s projection? The answer is 3.77-4.03%. While those rates are not impossible, it remains highly unlikely given the average growth during the recovery, as the figure below makes apparent.


The September Jobs Report

The BLS (after reopening from the government shutdown) released the Employment Situation report for September, leaving the broad landscape of the economic recovery pretty much unchanged. The Great Recession is still casting a long shadow over the labor market as employment growth continues to be anemic and the employment/population and labor force participation remain at the lowest levels in more than thirty years. As we noted in an earlier blog, the weakness in the labor market continues to play against the Federal Reserve’s earlier attempts to provide forward guidance about asset purchases and interest rates based on thresholds for the unemployment rate.

Non-farm employment increased by 142,000, below most economist’s expectations. The private sector added only 126,000 jobs, of which 100,000 came from the service sector: the largest gains in Transportation and Warehousing (23.4k), Retail Trade (20.8K) and Temporary Help Services (20.2K). Given that the next report will come out on Friday November 8  (less than a month from this report) and that it will be influenced by the shutdown, it is unlikely to be very informative.



While a 142,o00 monthly employment gain is well below ‘normal recovery’ standards, the pace of improvement in the labor market has been consistent now for several years. Most labor market indicators have either returned to their pre-recession levels or are slowly nearing them. Consider the growth in non-farm employment:


While the level of employment has not yet reached its pre-Great-Recession peak in nearly six years, it has been climbing steadily. The monthly net employment gain has averaged 179,000 since January 2011.

The unemployment rate in September ticked down slightly from 7.3% to 7.2%. Initial claims, obviously affected by the recent shutdown spiked up, but the trend down is also indicative of an consistently improving labor market.



Interestingly, labor productivity measured by total output divided by the total number of labor hours looks very similar to all previous recoveries except for the 2001 cycle. Even as employment fell 5% below its peak level, productivity continued to rise.


As has been the case for some time now, the Taylor Rule indicates that the federal funds rate should be significantly higher than its current level. The rule prescribes an interest rate policy given the how far unemployment and inflation are from their long run stated targets of 6.5 and 2 percent, respectively. If the targets are hit exactly, the Taylor Rule gives a 4% fed funds rate. Currently, the rule suggests a rate of around 2%, well above the zero bound where the fed funds rate has been since 2010.


The question is what exactly the Fed is looking at that suggests that there continues to be a sufficient need to keep interest rates near zero and the rate of asset purchases high. One labor market indicator that might be particularly worrisome is the employment to population ratio. The employment to population ratio compared to all other recoveries looks much different, it fell nearly twice as much and has shown very little recovery.


Indeed, the ratio is now about what is was back in the early 1980′s. Unfortunately, we do not have any way of really knowing what this ratio “should” be! The reason is that female labor force participation, baby-boom retirees, schooling decisions and a host of other things determine the numerator, not just how many get employed given they choose to work. In other words, it is by no means clear that it is expected to rise back to its level in the year 2000 or even 2007. Note, though, it appears to have stabilized over the past few months.


Another possible troubling trend is the relationship between unemployment and job vacancies, referred to as the Beveridge Curve.  Below we plot the vacancy-unemployment relationship since 2000. The variables moved down and to the right during the previous recession as job vacancies fell and unemployment rose. During the recovery it has shown a counter-clockwise loop as it moves back up to the left. This movement is not unexpected as noted by the Diamond-Mortensen-Pissarides workhorse model of search unemployment. The vacancy data in this graph come from JOLTS, however, these data only started in December of 2000.


The graph below uses a different data set (now defunct), the help wanted advertising index from the Conference Board, but we have only used the data from 1951-1998. This is the series that was formerly used by those looking at job vacancies before the advent of JOLTS. The colors indicate different decades. Ok, just as a quick quiz: Where are the 1950s on the graph and where are the 1990s?


The answer to the quiz can be found here. The point is that the outward shift in the  Beveridge Curve might come about for different reasons. First, as noted in the standard labor search framework, the counterclockwise movement comes about since firms can quickly post vacancies, yet matching firms to workers takes time. However, outward shifts can occur due to skill mismatch, here is an example, or changing demographics. It’s not clear which factor is causing the trend in the Beveridge curve since 2010, as it is also not clear what the role of monetary policy is in correcting the outward movement.

GDP grows by 2.5% in first quarter advanced estimate

The Bureau of Economic Analysis announced here that real GDP increased by a seasonally adjusted annual rate of 2.5%. The increase was fueled largely by personal consumption expenditures (contributing 2.24 percentage points to the overall 2.5 percentage point increase).



What worked against the increase in real GDP growth was a large decline in government spending along with a big rise in imports.  Although this report represents yet another quarter of growth below the long run trend, it was positive growth in contrast to Europe which is sinking back into recession.

On the bright side, the economy continued to generate positive growth without the boost from Government spending.  Signs that housing markets contributed to the positive growth represent an encouraging phase in the recovery–historically, housing  has led the economy out of contractions.





The bar graph shows another way of looking at the recent behavior of real GDP. The bars in the graph show the quarter-to-quarter change (s.a.a.r.) in real GDP while the blue line indicates the year-over-year change (s.a.a.r.). The first thing that stands out is the very large decline in real GDP during the last recession. The recession in the earlier part of the decade hardly looks like a recession at all in comparison. And, while the quarterly change in Q1 was 2.5%, the year-over-year change between 2013Q1 and 2012Q1 was 1.8%. Moreover there appears to be somewhat of a decline in the average year-over-year change: the average pre-2001 recession year-over-year change was higher than that in the years between the 2001 recession and the recession beginning in 2007 and that is higher than the recovery phase starting in June, 2009 (according to the NBER business cycle dates).


An alternative way to think about long-term economic growth is to decompose real GDP into a trend component and movements around this trend, that is, the cyclical component of the business cycle.  Many economists use the Hodrick-Prescott (HP) filter to do this decomposition. The HP filter, however, has some issues that we have pointed out previously here about estimating the growth trend at the end of the data series.

If one believes we will eventually get back to 2% real growth, the trend line will be something like the dashed red line in the following two graphs. The green line represents the HP filter’s trend which equates to about 0.8% annual GDP growth.

2005 cutoff - trend

2005 cutoff - trend zoomed

The implication of this is that the recent recession and recovery will appear much worse if we believe that GDP will grow at 2% over the long term. The red dotted line in the graph below has shown no signs of returning to the historical trend, and won’t, as a long as the quarterly report consistently comes in below 2 percent. On the other hand, if you believe that the financial crises and Great Recession inherently altered the growth potential of the US economy and that the long-term growth trend has shifted down, as the green line shows, then the recovery doesn’t look nearly as anemic. In fact, with this view GDP has already recovered and is above trend.

Many may be aware of what has been called the Great Moderation, a period where the volatility of real GDP declined markedly–between the mid 1980′s and 2007. While some have mentioned that this may be the result of better policies, the recent episode may suggest that the great moderation was nothing but a series of smaller, or less consequential shocks.

2005 cutoff - cyclical deviation zoomedIf one believes that we will once again move to the sustained 2% growth path, then the graph above leaves plenty of room for concern in the short-term.

Snapshot: Household and Corporate Finances

Data released by the Federal Reserve shows that household sector debt outstanding rose at a 2.5% annual pace in the last quarter of 2012. It was the first time since the beginning of the recovery that household debt didn’t fall as a percentage of GDP. Households had been steadily de-leveraging until the most recent quarter. Debt to GDP remains 15 percentage points below its level at the peak of the cycle and those levels will not likely be seen again soon. Total borrowing by the household sector also increased in the fourth quarter, indicating that the household sector is willing to take on additional debt in this very low interest rate environment.



In terms of net worth (assets minus liabilities), households’ balance sheets are slowly improving, aided by a recovery in the housing sector and rising equity prices. As a percentage of GDP, the fall in household net worth from the peak in 2007 was 4 times as severe as the fall caused by the dot-com bust that spurred the 2001 cycle. The difference, of course, was the collapse of the housing market. The total market value of real estate assets fell 40 percent more than the fall in GDP. This was combined with a similar fall in the value of household’s holdings of financial assets.



Non-financial business corporate debt rose at an even faster pace in Q4 (8.75% annually). A large portion of the increase was due to increased corporate bond issuance.



There has been a lot of talk (here is one example) about how corporations are hoarding cash and are reluctant to invest earnings. The figure below shows the amount of checkable deposits and currency held by the non-financial corporate sector (only one form of liquid assets corporations hold).


The total size of this cash hoard is now nearly twice as high as it was before the peak of the cycle and nearly $400 billion higher than at the trough. Before you make the call in favor of hoarding though, take a look at the evolution of total currency and deposits as a percentage of total assets.


As a percentage of total assets, the business corporate sector’s holding of currency and deposits is relatively low and is returning to the levels of the 1980′s. A similar picture can be shown looking at a broader category of liquid assets (including savings, time depots, mmmfs, etc.). There doesn’t seem to be any extraordinary behavior on the side of firms. Similarly, households appear to be carrying relatively low levels of cash and deposits relative to total assets.



Fiscal Policies Matter! GDP Down Income and Savings Up in Anticipation of The Tax Hikes

The advance estimate of Q4 Real GDP released on Wednesday showed that US output contracted by 0.1 percent in the final quarter of 2012. The effect of fiscal policies as well as weakness of the European economy and the rest of the world can clearly be seen in the negative aspects of the report.  The overall decline was due to a reduction in  exports (-5.7%) and a rundown in inventories as well as a large decline in government spending (-6.6%) caused by a 22.2% cut in defense.

The negative headline number hides overall positive growth in domestic fundamentals. Consumption expenditures on durables increased at a faster pace than in Q3, and both residential and non-residential fixed investment recorded the highest combined growth since the second quarter of 2010. There are signs that spending on services and non-durables are slowing down, which will be a cause of concern if the trend continues into 2013.

Fiscal policies matter. The expected end of the payroll tax holiday had a large effect on personal income and savings toward the end of the year. In the final two months of 2012, real disposable personal income increased by 1.3% and 2.8% in November and December. This is in stark comparison to the .14% growth in the first 10 months of the year. The run-up in income can almost entirely be attributed to companies shifting dividend payments forward. The result lead to a jump in the savings rate, up to 6.5%, but no apparent change in personal consumption expenditures.

                           Aug.     Sept.    Oct.     Nov.     Dec.
                           (Percent change from preceding month)
Disposable personal income:
  Chained (2005) dollars  -0.3      0.1     -0.1      1.3      2.8
Personal consumption expenditures:
  Chained (2005) dollars   0.0      0.5     -0.2      0.6      0.2

Personal Savings Rate      3.6      3.3      3.4      4.1      6.5

Inventory Changes

Interpretation of the downward change in business inventories is difficult. The negative view is that businesses are cutting back on production for fear of weak demand in the future perhaps in anticipation of tax and spending cuts in the New Year. The positive view is that sales in the fourth quarter were unexpectedly high. So the question that really should be asked is when are negative inventory changes indicative of a slowdown in output?

A first step is to see how inventories are related to the business cycle. The graph below shows the real change in private inventories adjusted for the level of output (in red) and the business cycle component of real GDP (in blue) since 1970. Inventories are positively correlated with output and tend to lead the business cycle, meaning that generally inventories decline before output. However, the change in inventories is noisy. A quarter decline is much less informative than a prolonged period of inventory depletion. The implication is that we will have to wait a bit longer  to understand the full importance of the recent decline.



As always, we show the components of GDP measured from the peak of the business cycle.


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