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Sunday, May 1, 2011

Breaking Down the Q1 GDP Report

While the Q1 GDP report this week was certainly disappointing, I'm not sure that some fully understood why the top line number was as weak as it was. The financial press seems to have gotten it right, but I've seen some more on-the-street commentary attribute it to the high gas prices. Since those were mostly a March phenomenon, this seems unlikely. 

Additionally, when you peel the various pieces of the report apart, it is clear that the weakness came from one thing more than anything else: weak government spending. Contractions in federal, state, and local government expenditures shaved more than a full percentage point off of the annualized growth rate in the first quarter. A full two thirds of that change is attributable to a drop in national defense expenditures, which are fairly volatile due to the unusual timing of larger orders. National defense expenditures added smartly to GDP growth in Q2 and Q3 last year, but took away growth slightly in Q4 of 2010 and this year's Q1. As for state and local governments, most of it happened on the investment side, which would indicate less road building, upgrades at state and municipal-owned utilities, and so on. 

Now, before anyone says, "Well, that's just government and it doesn't matter what is happening there. The private sector is doing comparatively well," I feel constrained to remind them on how GDP is calculated. Each category is calculated at the point of final consumption. The means that government is the final consumer of certain goods and services that are actually, more often than not, obtained from the private sector. The upshot of this is that if weak government spending is holding overall consumption and investment down, it is a real phenomenon of less spending happening in the economy, not just an accounting vagary. 

The effects of higher gas prices were not yet felt in full in Q1 as personal consumption was modestly strong and the trade deficit did not noticeably widen. So far, high frequency indicators of retail sales such as the weekly retail sales reports do not indicate grave weakness, but the regional manufacturing indexes put out by the various Federal Reserve banks showed signs of strain, though we are still in robust expansionary territory. This all bears watching. One or two months of these prices is a sustainable event; four, five, or six becomes a problem. Higher fuel prices have a pernicious effect on economic growth in all sectors. 

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