Friday, January 30, 2009

Q4 GDP - Real GDP vs. Final Sales

I'm seeing plenty of headlines this morning highlighting how GDP supposedly came in much better than expected at down 3.8% (annualized) versus an expectation of down in the 5-5.5% range. As always, the devil is in the details.

Not too surprisingly, personal consumption and private investment both fell significantly, -3.5% and -12.3% respectively. The key figure in understanding the headline number, however, is the change in inventories. Real inventory growth in the quarter had the effect of adding 1.32 percentage points to real GDP. When we ignore this inventory build, we get a figure known as final sales. Final sales fell 5.1% in the quarter.

Inventory was reduced by $50.6 billion in the second quarter and $29.6 billion in the third quarter. Why did inventory grow in the fourth quarter? It can most likely be attributed to a weak holiday selling season combined with a little too much optimism. Retailers didn't sell as much as they hoped, so they ended the quarter sitting on extra inventory which left excess inventory at the wholesaler/manufacturer level.

Why is this important? If an inventory build occurs to prepare for future growth then there shouldn't be a problem. However, to the degree that any increase in inventory can not be met by demand, we are effectively borrowing production from a later period.

The bottom line is that an inventory build that isn't met by current demand will result in lower future GDP since production will need to be scaled back to reduce the excess inventory. It's kind of like getting an advance on your paycheck. Your income may have technically gone up today, but that "loan" has to be paid back. With the global economy clearly slowing further over the past month, this "better than expected" GDP report will likely lead to a weaker report next quarter -- at least weaker than it would have otherwise been.

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