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A weaker-than-expected Q4 GDP points to a stronger Q1




The government's first guess at the growth of fourth quarter GDP was less than expected (3.2% vs. 3.5%, with some expecting 4-5%), but if that is the reason for today's market selloff, then this is another good buying opportunity. GDP estimates can and do change significantly over the years, of course, but meanwhile, the main reason that Q4 growth was disappointing was that there was a large decline in inventories. As the chart above shows, inventories subtracted a full 3.7 percentage points from Q4 growth. As Brian Wesbury notes, real final sales (real GDP excluding inventories) rose at a very impressive 7.1% annual rate last quarter, with the result that:

... manufacturers and retailers underestimated consumer demand and ran down inventories dramatically in the fourth quarter. Anecdotal reports suggest that low inventory levels are having a cost in the form of lost sales. Moreover, prices are not likely to be slashed to reduce excess inventories after the holidays. What this means is that there is more room for production increases in 2011 and inflation will continue to move higher.

It is quite likely that businesses are already attempting to rebuild their inventories, but even if they manage to hold them steady, that will have the effect of boosting first quarter growth. I recall quite a few times in the past where a weak GDP number caused by inventories was followed by a stronger number in the subsequent period. It's likely to happen again.

I needed a 4% Q4 print to make my Dec. '09 prediction of at least 3% growth in 2010 be correct. If the first estimate stands, then I will have overestimated growth by 0.2%. Not too bad, but it was my optimism on the economy's growth prospects that led me to mistakenly expect the Fed to begin tightening policy last year, and to expect bond yields to be higher than they turned out to be. But just because I overestimated growth last year does not mean I need to cut my growth expectations (at least 4%) for this year. Stronger growth is likely because confidence is up, uncertainty is down (e.g., the tax cut extension passed), global growth remains very strong (e.g., China and India), fiscal policy headwinds are slowing (e.g., no more wasteful stimulus experiments), and monetary policy remains very accommodative.


Another thing I did not expect was the very small rise in the Q4 GDP deflator (0.26% annualized), which contributed to a very small rise in the nominal growth of Q4 GDP: 3.44%. The very small gain in the deflator last quarter could be just a one-time event, since as the chart above shows, on a year over year basis both the deflator and the Employment Cost Index look to have bottomed. Regardless, relatively slow growth in nominal GDP, alongside somewhat faster growth in M2 in the fourth quarter, resulted in a modest decline in M2 velocity (see chart below), whereas I had been expecting a pickup. But again, that is not a reason to get bearish on 2010. It still makes sense for velocity to pick up (confidence is improving, and the dollar is weak, which suggests that money demand is declining on the margin even as the Fed remains very accommodative), and it is also the case that M2 growth appears to be accelerating a bit.

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