ECONOMIST on U.S. GDP growth

["Devine, James" <jdevine@xxxxxxx>]

Economist.com/America's economy
May 4, 2002
FINANCE & ECONOMICS
A hard act to follow

ON THE face of it, America's economy is roaring back. In real terms, its GDP
grew at an annual rate of 5.8% in the first quarter. It leaves the rest of
the world far behind: Britain's economy grew by just 0.3% in the same
quarter, while the pace for Japan and the euro area is reckoned to have been
no more than 1-2%. America's numbers look almost too good to be true--which
may be why they were followed by falls in share prices and the dollar.

Dig beneath the headline figure for growth and America's performance looks
less miraculous. Almost four-fifths of the bounce in GDP came from firms
reducing their inventories at a slower pace than in the previous quarter,
and from a big jump in government spending. Defence spending grew at an
annual rate of 20%. At the same time, residential construction, up an
annualised 16%, was given a temporary boost by one of the mildest winters on
record. Total final sales (which does not count changes in inventories) rose
at an annual rate of only 2.6%, If one also strips out the jump in defence
spending and, to take a rough guess, half of an unsustainable boom in
construction, then growth falls to a mere 1.5%.

Consumer spending rose by a reasonable 3.5%, but fixed investment by firms
fell, for the fifth consecutive quarter. Alan Greenspan, the chairman of the
Federal Reserve, has said repeatedly that a pick-up in investment is
critical for a sustained economic recovery. But that, in turn, requires
stronger profits.

The new GDP numbers not only showed that growth is less robust than it
seems, but that inflation is unusually weak. The GDP deflator--the amount by
which nominal GDP is adjusted to take inflation into account--rose at an
annual rate of only 0.8% in the first quarter, to give a year-on-year rise
of 1.3%. It will probably fall further: in the past, the GDP deflator has
fallen on average by more than one percentage point in the first year of a
recovery, as productivity has rebounded faster than costs.

An unusually low rate of inflation, combined with uncertainties about the
strength of the recovery, has two big implications. First, the Federal
Reserve is unlikely to raise interest rates in the near future. It will not
want to run the risk of allowing inflation to get too close to zero, where
options for conducting monetary policy rapidly dwindle. Second, the lack of
pricing power is likely to result in a weaker rebound in profits than in
previous recoveries, dampening stockmarket hopes.

The S&P 500 index remains one-third below its 2000 peak. Uncertainty about
profits is not the only factor that weighs on share prices. Lombard Street
Research points to something else that may hold down equities: tighter
liquidity. America's broad-money supply, measured by M3, has slowed sharply
in the past three months. Usually, when the money supply grows faster than
GDP, excess liquidity spills into financial markets--as happened late last
year. When money-growth falls below GDP growth, liquidity tends to be
drained out of markets, pushing down share prices. Were the stockmarket to
slide further, strong consumer spending, the main driver of GDP growth in
the first quarter, might come into question.

Copyright © 2002 The Economist

Jim Devine jdevine@xxxxxxx &  http://bellarmine.lmu.edu/~jdevine