US GDP declines in Q4 but report not as bad as it seems

Payback

Real GDP fell 0.1% in the fourth quarter, after rising 3.1% in the third. The fourth quarter drop should be viewed as payback for a strong third quarter, not as a signal that the economy is tipping into recession. The outcome was even weaker than the positive 0.3% rate that we had anticipated in our "Week Ahead" review last Friday (25 January) – but the weakness came exactly where anticipated. The two factors that had helped the third quarter – defence spending and inventories – went into reverse during the fourth quarter, subtracting a combined 2.6 percentage points from the growth rate. These are massive – but temporary – corrections. Even though the trend in real defence spending is downwards – how steeply will depend on whether the sequester takes effect – the fourth-quarter drop is still a major outlier.

The news from private spending was mostly encouraging. Consumer spending growth improved from 1.6% to 2.2%, while residential investment growth accelerated to 15.3% as the housing recovery gathered pace. Business fixed investment rebounded 8.4%, after dropping 1.8% in the third quarter. Some of the bounce in equipment and software spending (which rose 12.4%) may have reflected spending pulled into 2012 ahead of the possible expiration of bonus depreciation. Only exports disappointed, dropping at a 5.7% annual rate, with very sharp drops for food exports (likely drought-related) and in aircraft exports (a volatile category).

Not a cliff jump

It is hard to pin the weak fourth quarter on fiscal-cliff fears. Consumer and business fixed investment spending did better than in the third quarter – though perhaps some of the slowdown in inventory accumulation reflected caution ahead of the cliff. Hurricane Sandy also hurt growth, although it is impossible to know how severely (our assumption has been that it was a drag of 0.3 percentage point).

It would be a mistake to view this drop in GDP – driven by severe, temporary corrections in defence spending and inventories – as a possible harbinger of recession. This report is nowhere near as bad as it looks on the surface. The incoming data point to continued growth, and we expect GDP growth to rebound to around 2% in the first quarter, even though consumer spending growth is likely to slow as the end of the payroll-tax cut bites. At present, our forecast assumed that the sequester does not kick in as scheduled on March 1 – if it takes full effect, that would take around a quarter-point off our growth forecast for the first quarter.

Outlook and implications

The most obvious effect of the fiscal cliff in the GDP report was on the income numbers. The Bureau of Income Analysis (BEA) estimated that an extra USD26.4 billion (USD105.6 billion at an annual rate) was paid to persons in special or accelerated dividends, ahead of an anticipated increase in the dividend tax rate. It also made a smaller judgmental adjustment of USD15 billion at an annual rate to wages and salaries to allow for accelerated bonus and other payments. The combined effect of these two items added USD120.6 billion at an annual rate to personal income in the fourth quarter. The result was that personal income rose at a 7.9% annual rate in the fourth quarter; without the extra USD120.6 billion it would have risen at a 4.1% annual rate. Personal income for December, to be published today (31 January) will probably rise more than 3% month on month. We expect personal income to fall in the first quarter, as the extra dividend and bonus payments drop out, and as the elimination of the payroll-tax cut reduces income as well.

At present, we do not have information about BEA assumptions on taxes paid on the extra income, but since there was no surge in taxes paid comparable to the surge in dividends, it seems that the BEA has assumed that the taxes due on the extra dividends will be paid in final settlements in 2013.

The extra income payments assumed for the fourth quarter are irrelevant for GDP, since they do not correspond to any extra production, except to the extent that the recipients used them to finance extra spending. That effect was probably very limited. With the vast majority of the extra income being saved, the personal saving rate jumped to 4.7% in the fourth quarter, from 3.6% in the third.