Sharp Downward Revision of U.S. Q4 Growth Dents Optimism

Sharp Revision

Fourth-quarter GDP growth has been revised down sharply to 2.2%, from 3.5%. Although the revision was expected (Global Insight had anticipated 2.1%), it is no less unwelcome. It erases the picture of an economy rebounding and gathering momentum at the end of the year. Instead, the fourth-quarter growth rate is now little changed from the 2.0% rate in the third quarter. The figure for final sales to domestic purchasers—spending by U.S. residents on everything except inventories—was revised down to 2.0%, from 2.4%, matching its 2.0% growth in the third quarter. This suggests continued sluggish domestic spending growth (with housing still the biggest drag). A GDP revision of this magnitude is unusual. The average "first revision" of GDP growth is 0.5 of a percentage point. Today's revision of 1.3 percentage points has been matched or exceeded only seven times in 30 years. Usually, revisions to the various components of GDP tend to offset one another. On this occasion, all the revisions were negative.

Roughly half the revision came in inventories. A slowdown in inventory accumulation is now estimated to have subtracted 1.4 percentage points from growth, instead of 0.7 of a percentage point. A massive downward revision in wholesale inventories more than explained the overall inventory adjustment (real wholesale inventory accumulation was revised down from US$35 billion to just US$8 billion). The rest of the revision was spread across most major categories of spending. Consumer spending growth, although still strong, was revised down (deducting 0.2 of a percentage point from overall growth). Another 0.2-percentage-point deduction came from business fixed investment, where the original 0.4% decline was revised to a 2.4% decline. The improvement in net exports was not as sharp as was originally believed to be the case, deducting 0.1 percentage point from growth (imports fell less than first thought). In addition, government spending growth was revised down slightly. The only major category that did not suffer a downward revision was residential construction—but that already had a huge decline of 19% (a 1.2-percentage-point drag on growth).

What are the implications for future growth? One might argue that with inventory accumulation lower than we thought, the adjustment of production to slower sales growth is further along, which helps clear the decks for faster future growth in production. This, however, is too simplistic a view. While the inventory adjustment may be more advanced than we thought, we do not know how far it ultimately has to run. The adjustment may end up being deeper than previously expected. The decline in manufacturing production during January suggests that the adjustment was indeed deepening as the first quarter began. What is more, the growth revision was not confined to inventories. Most categories of final sales were revised down. Consumer spending still looks on course for a gain of around 3% in the first quarter, but given the poor durable goods report for January, it is now very unlikely that business fixed investment will rebound quickly after its fourth-quarter decline, as we had previously anticipated.

The upshot is that we do not expect an unwinding of the inventory adjustment to give us a first-quarter bounce, and we anticipate that we will be revising down our first-quarter GDP forecast of 2.5%, taking it closer to 2.0%.

Other Key Data

• Core Personal Consumption Expenditures (PCE) inflation was revised down to a quarter-on-quarter annualised rate of 1.9%, from 2.1% (that is, falling back within the Federal Reserve's 1-2% comfort zone). However, on the less volatile year-on-year basis that the Federal Reserve watches more closely, core PCE inflation at 2.2% remains too high for its comfort.
• Based on the reduced estimate of output growth, productivity growth for the fourth quarter will be revised down very sharply, probably to around 1.3%, from the original estimate of 3.0%.
• New information on wages and salaries suggests that January personal income (to be published today) may rise sharply. The Bureau of Economic Analysis has estimated that irregular pay, such as bonus payments and gains on the exercise of stock options, added about US$50 billion to fourth-quarter wage and salary accruals. These payments will kick into wage and salary disbursements in the first quarter (accruals occur when pay is earned, disbursements occur when it is paid out). This will bump up personal income growth in the first quarter. We have no information on how the disbursements will be spread across the three months in the quarter, but if they are placed evenly in January, February, and March, the growth rate of personal income in January would be bumped up by about 0.4 of a percentage point.
• The downward revision to fourth-quarter nominal GDP and the upward revision to wage and salary accruals suggest that profits were squeezed in the fourth quarter. We will have to wait for official estimates of profits, but it seems likely that profits from current production fell on a quarter-on-quarter basis for the first time since the first quarter of 2003 (excluding hurricane-affected quarters).

Outlook and Implications

Although the GDP news was not a surprise, it will add to the sense of unease about the economy that contributed to the stock market plunge two days ago. China may have been the trigger, but against the background of a warning about recession risks later in the year from former Fed chairman Alan Greenspan, the recent carnage in the sub-prime mortgage-lending sector, and a plunge in January durable goods orders, U.S. markets were unable to take the China sell-off in their stride, as they otherwise might have done.

Global Insight still views a recession this year or next as a low probability (15% or less). The stock-market plunge appears to us to be a timely reminder of risks rather than a harbinger of recession. Nonetheless, we do not expect a quick return to trend growth (3%), with the first quarter likely to come in closer to 2.0% than 2.5%. As the year progresses, we expect to see a gradual improvement in growth as the housing drag diminishes. For 2007 overall, the lower starting point for GDP guarantees that our next forecast of growth will be revised down from 2.7%, probably to the 2.4–2.5% range. We still see the Federal Reserve as on hold for the time being, with core PCE inflation still running above its comfort zone. Last month, we anticipated that the Fed would cut interest rates by 25 basis points in September, as inflation finally eased back into the comfort zone, but the weakness in today's data, and the apparent sluggish start to 2007, could bring that cut forward.

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