(PCE) First Quarter GDP Revised Up to 1.9%

This is effectively the same post as I put out when the earlier looks at GDP in the first quarter were released. The numbers from the current release are in italics, while those from the second release are in bold while those from the first release and for previous quarters are in normal font. This allows you to see exactly where the changes in the contributions to growth are coming from. New commentary will be in both bold and italics.

Overall this is a slightly positive report. The headline number came in a tick better than expected and higher than last time. The sources of the upward revision were mostly low quality. On balance, all of the upward revision can be traced to faster inventory rebuilding, although there were other cross-currents as well.

In the first quarter, the economy grew at an annual rate of 1.9% (1.8%, 1.8%), down from 3.1% in the fourth quarter, and from the 2.6% pace in the third quarter. The growth rate was above consensus expectations of 1.8%. The first graph (from here) shows the history of GDP growth.

Where Did the Growth Come From?

So how did we get to the 1.9% (1.8%) overall growth? What parts of the economy were growing and thus adding to growth and which parts were acting as a drag on growth? Since the different parts of the economy are of very different sizes — and some tend to be relatively stable while others can be very volatile — I will focus on the contributions to growth.

In other words, growth points, not the percentage growth rates. After all, a small percentage change in a very big part of the economy can have more impact than a big percentage change in a small part of the economy. To do this I will follow the familiar Y = C + I + G + (X – M) framework, where Y = GDP, C= Consumption, I = Investment, G= Government, X = exports and M = imports.

C is for Consumer

The biggest part of the economy by far is the Consumer, or consumption, or to be more specific, Personal Consumption Expenditures (PCE). It represented 71.2% of the overall economy in the fourth quarter, and was the biggest growth driver. PCE contributed 1.52 (1.53, 1.91) growth points, down from 2.79 points in the fourth quarter but up from 1.67 points in the third quarter. The drop in contribution from PCE is exhibit A for how the quality of the growth deteriorated from the first data release to the current one.

Over the long term, our economy is already weighted far too much towards C, and that contribution has been rising over the years. Back in the 1960’s it represented more like 64% of the overall economy. Our consumption share is also far higher than most other economies in the world.

Still, we need consumers to be opening their wallets for the economy to grow, at least in the short term. This is high-quality growth, and is very welcome in the current environment.

Goods & Services

Consumption can be broken down into two main categories: goods and services. Goods can be further broken down into durable goods — which tend to be big ticket items that will last more than 3 years — and non-durable goods — which tend to be consumed right away. (For some reason clothing is categorized as a non-durable good. Clearly the people making those decisions have never looked into my closet.)

Services are by far the biggest part of consumption at 65.96% of PCE and 46.96% of overall GDP. It chipped in 0.61 (0.69, 0.80) growth points, down slightly from contributing 0.70 points in the fourth quarter and from a net contribution of 0.74 points in the third quarter. This a mediocre contribution — not awful, but certainly not robust either.

Services tend to be “produced” domestically, not in China, and also tend to be more labor intensive than goods producing jobs. Normally demand for services is more stable than demand for goods, especially durable goods.

Within the consumption of goods, consumption of non-durable goods is about twice as large as the consumption of durable goods. However, since people can defer purchase of durable goods like an auto from Ford (F) more easily than they can defer purchase of a box of corn flakes from Kellogg’s (K), durable goods demand is very volatile. As a result, durable goods tend to “punch above their weight” in determining is the economy is booming or slumping.

Durable goods consumption added 0.68 (0.66, 0.78) points to growth, down sharply from an addition of 1.45 points in the fourth quarter but up from 0.54 points in the third quarter. While that contribution is not bad, the sharp slowdown is a bit disheartening. The sector is only 10.88% of PCE and 7.75% of overall GDP, yet it contributed 43.33% of the overall GDP growth in the quarter. Early in recoveries it tends to have a bigger positive impact, but it also has a big negative impact when the economy falls into recession.

Non-durable goods are 23.15% of PCE and 16.48% of overall GDP. The sectors contribution to growth fell to 0.23 (0.17, 0.34) points in the first quarter from 0.65 points in the fourth quarter and 0.39 points in the third quarter. While one does not expect big flashy moves in this part of the economy’s contribution to growth, it is stall a major part of the overall economy. The small upward revision is welcome, but the overall contribution from this part of the economy is still disappointing.

Overall, the Consumer is doing his and her part in getting the economy rolling again. The strong contribution from the consumer service sector was encouraging. All three parts made contributions to growth, but much less so than in the fourth quarter.

While over the long term we can worry that far too much of the overall U.S. economy is dedicated to consumption, and not enough to investment and exports, for right now we want to see the Consumer alive and kicking. Without a doubt he was in the first quarter, but not kicking as hard as at the end of last year.

I is for Investment

Investment tends to be the most volatile part of the economy, and thus is the major reason why the economy either booms or busts, even though it is a relatively small part of the overall economic picture. Overall Gross Domestic Private Investment (GDPI) is just 12.42% of the overall economy. Overall GDPI added 1.46 (1.45, 1.01) growth points in the first quarter, a sharp reversal from subtracting 2.61 points in the fourth quarter but down from the 1.80 point contribution in the third quarter.

The increase in contribution from GDPI is encouraging, at least at first glance. But don’t break out the champagne yet. When one looks a bit deeper, the picture is much less encouraging.

Investment is the key to future growth, and as a share of the economy it is much lower than most other economies. However, not all investment is of the same quality. Fixed investment, particularly investment in equipment and software, is investment that tends to have a positive return on investment and which then drives future growth.

But not all investment is fixed. If companies build up their inventories, that too is counted for as investment, and it tends to be of very low quality. If companies are simply adding to store shelves, and those goods just sit there, then the investment in inventories will be reversed in later quarters. This is exactly the dynamic we are seeing in the first quarter numbers.

The inventory cycle is a powerful driver of booms and busts (recessions from 1946 through the early 1980’s were mostly due to the inventory cycle, or at least had the inventory cycle as one of the major components).


The increase in inventories accounted for most than all the overall increase from GDPI. Inventory investment added 1.31 (1.19, 0.93) points to growth in the first quarter. That is a sharp reversal from the fourth quarter, when lower inventories subtracted 3.42% from the overall growth. In the third quarter, inventories added 1.61 points to growth. In other words, in the first quarter, 66.1% (1.19/1.8) (51.7% [0.93/1.8]) of the total growth came from adding goods to the shelves, not from people actually buying the stuff on the shelves.

This is very low quality growth, especially when it happens for several quarters in a row, and we had five of them where inventories were a big positive player in providing growth. Then again, those came after eight quarters in a row where inventories were a drag on overall growth.

Clearly inventories can have a big influence on overall growth, but they tend to be very low quality growth. There does, however, seem to be somewhat of an inverse correlation with net exports, which I discuss below. The contribution from inventories was large relative to overall growth, but not particularly big in absolute terms. In other words not so big as it is likely to turn negative in the second quarter.

The difference in inventory investment between this release and the last one is more than the overall increase in the GDP estimate. Thus it is hard to get too excited about the overall uptick in estimated growth. However, as I discuss below, that was offset by a smaller drag from imports.

If inventories had just been a non-factor, the economy would have been crawling along at a 0.6% growth rate — down from an awesome 6.5% growth rate in the fourth quarter. The pace of growth ex-inventories is slightly below what we were running in the third quarter (1.0%) and in the second quarter of last year (0.9%).

Residential vs. Non-Residential Investment

Fixed investment can be broken down into residential investment (mostly homebuilding) and non-residential (or business) investment. Residential investment has been the major thorn in the side of the economy for a long time now. That changed a bit in the fourth quarter, and we appear to be slowly forming a bottom in residential investment, it being up in two of the last three quarters.

In the fourth quarter, residential investment added just 0.07 points to growth, but that is a big swing from the 0.75 point drag in the third quarter. In the second quarter, fueled by the first time buyer tax credit, residential investment added 0.55 points to growth, but that was a big exception to the recent trend. The first quarter was back to more “normal” form subtracting 0.05 (0.09, 0.07%) from overall growth.

Residential investment is now just 2.21% of the overall economy, down from well over 6% of the economy at the peak of the housing bubble. Normal is about 4.4% of the economy. While the levels are still just plain awful it has shrunk so much that it is hard for it to have that much of an effect on the overall rate of growth. Residential investment has been a drag on GDP growth in 15 of the last 18 quarters.

We still have a massive overhang of existing homes for sale (including those in foreclosure, and those which are likely to be foreclosed on). Most estimates of the amount of excess housing available today put it at about 1.5 million housing units. I am expecting a very slight positive contribution from residential investment in the second quarter.

With that much excess supply, building more houses is at one level simply a massive misallocation of resources. On the other hand, residential investment has always been historically one of the most important locomotives pulling the economy out of recessions. That locomotive is derailed this time around.

Residential investment is extremely volatile, and as such tends to “punch far above its weight” when it comes to the overall growth rate of the economy. The lack of residential investment is one of the key reasons that the recovery so far has been so anemic. Eventually population growth and new household formation will absorb the inventory overhang, and residential investment will pick up. That, however, it not going to happen right away.

Still, starting from such a low level, it seems likely that residential investment is likely to be a positive contributor to growth in 2011. Not a very big one; that is more likely a 2012 story, but simply by not being a major drag on the economy will be a major turn for the better.

That bump is almost entirely a function of just how small residential investment has become as a share of the overall economy. The overall bottoming process in residential investment is not over, and it will be a long time before it returns to its historical norm of about 4.4% of the overall economy. However, as it does, it will set off some very strong economic growth.

We are now at an all time low for residential investment as a share of the economy, as shown in the next graph (also from this source). Note how at the end of every previous recession, residential investment increased sharply as a share of GDP — in effect leading the economy out of the recession — but how it has persistently declined this time around. That is THE key reason that this recovery seems so sluggish.

Structures vs. Equipment & Software

Non-residential, or business, investment can also be broken into two major parts, investment in structures, such as new office buildings and strip malls, and investment in equipment and software. Investment in structures subtracted 0.41 (0.48, 0.63) points from growth in the first quarter. That is a very big negative swing from a contribution of 0.19 points in the fourth quarter.

I have to say the magnitude of the drop this quarter was a bit of a surprise, but not the direction. The revised number is more like what I was expecting in the first place. Vacancy rates are still extremely high in almost all areas of the country, and in almost all major types of non-residential real estate. We simply don’t need to be putting up a lot of new commercial buildings right now.

On the other hand, as the economy improves, we are starting to see some signs of those vacancies being absorbed, and prices for commercial real estate seem to be starting to firm up. The best leading indicator of future investment in non residential structures is the amount of activity among architects. That index moved back into positive territory during the winter, but has since slipped back.

Given the lead time, this suggests that we will have a positive contribution from non-residential structures starting in the third quarter, and then a bit more in the fourth quarter, before becoming a drag again in the first half of 2012. The reduced drag from investment in structures is the one area where the quality of growth actually significantly improved with the revisions.

Investment in equipment and software (E&S) is what we really want to see to power future growth, and there the news continues to be good, but not as good as we thought a month ago. E&S investment added 0.61 (0.81, 0.80) points to growth, which is not a bad showing since it is only 7.38% of the overall economy. That is still an improvement over the 0.54 contribution in the fourth quarter but down from the 1.02 point boost in the third quarter, and a 1.52 point contribution in the second quarter.

This is the eighth quarter in a row that E&S investment has made a positive contribution to growth. A year ago, investment in E&S was just 6.71% of the overall economy. That increase is highly encouraging, but we need to see it continue it climb as a share of the overall economy. This is probably the highest quality form of growth out there, as it is growth that feeds future growth. I would prefer to see even more growth coming from this front, but a 0.61 (0.81, 0.80) point contribution is still strong.

On the other hand, the big downward revision to this area is probably the most disappointing aspect of the report. The next graph, (also from here) shows the contributions to growth from the three components of fixed investment on a rolling four quarter average basis. Note the very sharp rebound in E&S spending, back up to the levels of the late 1990’s, relative to the persistent drag from investment in structures, both residential and non residential. (unfortunately, this graph is not updated with the revised numbers.)

Here is a different way of looking at the key parts of business investment spending, investment in structures and investment in equipment and software as a percentage of GDP. Unfortunately, this graph has also not been updated yet for the revisions, but it does give a good historical perspective on things. The rebound in E&S investment has been quite strong since the end of the recession, but it has not yet recovered to the share of the economy it commanded before the recession started. Investment in structures (which tends to lag the overall economy) has fallen to a record low share, offsetting the improvement on the E&S side.

Government Spending

Government spending subtracted 1.20 (1.07, 1.09) points to growth in the fourth quarter, down from a 0.34 point drag in the fourth quarter, and a 0.79 point addition in the third quarter. I should point out that in the GDP accounts it is only government consumption and investment that is counted as part of G. Transfer payments such as Social Security are not included. They tend to show up as part of PCE when Grandma spends her check.

What is counted is what the government pays in salaries to its employees (both civilian and military) and its spending on goods, from highways to fighter aircraft from Boeing (BA). The negative contribution from government this quarter just goes to show that a concretionary fiscal policy is, well, concretionary.

There is no such thing as growth inducing austerity. The zeal to cut government spending NOW, and hard, is having an adverse effect on the economy, and as the budget cuts go further, the drag from G is only going to get bigger.

The Federal government was big factor in the first quarter growth slowdown, subtracting 0.69 (0.68, 0.68) points from growth. It was essentially a non-factor in the fourth quarter, being just a 0.02% drag. That is down from adding 0.71 points to growth in the third quarter and from the 0.72 point contribution in the second quarter.

Overall Federal Government spending, as defined in the national income statistics, was 8.15% of the economy in the first quarter, down from 8.33% in the fourth quarter. Of that, 66.5% was spent on Defense, and 33.5% was on Non-Defense spending. Put another way, just 2.73% of the overall economy is non-defense federal spending (excluding transfer payments) and 5.42% of GDP is spent on defense.

Defense spending subtracted 0.69 (0.68, 0.68) points from growth, a much bigger drag than the 0.12 point drag in the fourth quarter. It contributed of 0.46 points in the third quarter and 0.40 points in the second quarter.

All things considered, if I had to pick one area to be a drag on growth it would be military spending. While making and dropping bombs does add to the economy in the national income statistics, it does not exactly build the economy or make people better off. That is not saying that it is not needed, but the less needed the better.

I suspect that the sharp drop in the first quarter is a bit of an aberration, though, and much of the spending will be made up in the second and third quarters. We are still involved in three wars (ok, 2 ½, but Libya is still costing real money).

The non-defense contribution was 0.00 (0.00, 0.00), down from a 0.10 point contribution in the fourth quarter and a contribution of 0.25 points in the second quarter. Last year we were still feeling the effects of the ARRA, but that spending is mostly over and now all of DC is looking to slash spending. Look for the contribution from the Federal Government, particularly the non-defense side, to turn negative over the rest of the year and probably into 2012.

Anyone who suggests that it is possible to cure the budget deficit by only cutting non-defense spending excluding transfer payments like Medicaid and Social Security is someone who quite simply should stay off of Jeff Foxworthy’s show, since they clearly are not smarter than a fifth grader. Social Security has its own dedicated revenue source, and has been running a surplus every year since 1983, and has thus been subsidizing the rest of the Federal Government.

State & Local Government

State and local governments were a 0.51 (0.39, 0.41) point drag on the overall economy, down from a 0.31 drag in the fourth quarter, and a 0.09 point contributor in the third quarter. Frankly, given the severe fiscal problems that most states are facing, and since they cannot borrow legally to cover operating deficits, the 0.51 (0.39, 0.41) drag is about what one would expect.

A big part (apx. 23%) of the ARRA has gone to helping state and local governments to help them avoid having to either cut spending drastically or rise taxes. The ARRA funding is starting to dry up. I would expect that S&L government spending will be a drag on growth in second quarter GDP and that the size of the drag will increase, but it will not be enough to put the economy back into recession.

However, private sector job creation is going to have to be extra strong to also absorb all the jobs lost at the state and local government level. Over the last year, 285,000 state and local jobs have been lost, creating a very substantial headwind to overall job creation.

(X – M) = Net Exports

The biggest negative swing by far in the first quarter was net exports, adding just 0.14 (subtracting 0.06, 0.08) points to growth. That does not sound that bad, but in the fourth quarter, net exports added 3.27 points to growth. In other words, if we had not had an improvement in the trade deficit in the fourth quarter, the economy would have actually fallen in the fourth quarter. That was a huge improvement over the 1.70 point drag in the third quarter and the massive 3.50 point drag net exports were in the second quarter.

Net exports being sort of a non-factor in overall growth is a bit of an anomaly. To some extent, this is a bit of the flip side of the inventory swing, since some imports go into inventories. As net exports tend to be very high quality growth, the fall from being a huge contributor to a minor drag is very bad news.

While overall net exports were a non-factor, the upward revision of them is very welcome news. Given the nice reduction in the trade deficit we saw for April, it is likely that net exports will be a more positive force in the second quarter.

The contribution from higher exports fell to 0.97 (1.16, 0.64) growth points from 1.06 points in the fourth quarter and below the 0.82 point contribution in the third quarter. The U.S. has actually been doing quite well on the export front, and we are well on our way to meeting President Obama’s goal of doubling our exports from 2009 to 2014.

Better exports have been a very big part of the recovery. The downward adjustment to the export contribution is a bit discouraging, but the overall level is still quite strong. The weakness in the dollar seems to be having a beneficial effect. That is very nice, but when it comes to GDP growth, it is net exports that count, not just exports alone. If our exports double, but our imports also double, we will be in a deeper hole than if both had remained unchanged.

Imports & Oil Addiction

It is the import side that was the massive swing factor. Each dollar of imports is a subtraction from GDP, so falling imports is a very good thing from a GDP accounting point of view. Falling imports added a stunning 2.21 points to growth in the fourth quarter, a massive turnaround from being a 2.53 point drag in the fourth quarter, and a 4.58 point drag in the second quarter. In the first quarter they were a 0.84 (1.12, 0.72) point drag.

While clearly we have seen worse, it is also the key reason why overall growth was so much lower in the first quarter than in the fourth quarter. I suspect that much of the increased drag from higher imports was due to higher oil prices. They may also have had an effect in the lower contribution from consumer spending as well.

The fall in oil prices since the end of April will be a big help to overall economic growth in the second quarter and beyond (provided no big rebound in them). However, that will probably be more of a third quarter story than a second quarter story. If we exclude the effects of international trade, growth would have been negative in the fourth quarter by 0.2%, not a positive 3.1%. In the first quarter, it would have been a positive 1.8%.

Can net exports go back to being a positive contributor?  A weaker dollar would sure help the cause, and there is plenty of room for further improvement. Net exports are still a huge drag on the economy.

Remember we are looking at changes here in the contributions to growth, not levels. Our trade deficit is unsustainably large. It is the reason why we are so in debt to the rest of the world, not the budget deficit. The budget deficit feeds into our overseas indebtedness only indirectly.

Over half of our overall trade deficit comes from our addiction to imported oil. Unfortunately, a weaker dollar is not likely to help significantly on this front, as when the dollar weakens, the price of oil tends to rise. However, a weaker dollar is very useful in reducing the non-oil part of the deficit. It makes imported goods more expensive, and therefore less competitive with domestically made substitutes. It also makes our exports more competitive.

Recently, though, the price of oil has been falling without a substantial strengthening of the dollar. That means we could be getting some progress on both sides of the trade deficit. The Fed recently reduced its growth forecasts for 2011 to 2.8%.

Part 2: http://www.stockbloghub.com/2011/06/24/wmt-first-quarter-gdp-revised-up-to-1-9-part-2/77421

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