Friday’s GDP report is going to look pretty strong. But beware its soft underbelly.

April 25, 2013

Three months ago, when the Commerce Department reported crummy economic growth numbers, there was a saving grace.

Sure, GDP had shown a surprising 0.1 percent drop in the final months of last year (later revised to a 0.4 percent gain). But it was mostly for fluky reasons that would reverse later on. Businesses cut back on inventories, for example, and there was a steep and not well understood drop in reported defense spending. Growth should, by all rights, snap back in the first quarter of 2013, economists said then.

Housing may be growing nicely, but it's from a verrry small base. (SOURCE: REUTERS)
Housing may be growing nicely, but it's from a very small base. (SOURCE: REUTERS)

Well, the first quarter has come and gone, and when the government reports GDP numbers Friday morning, it probably will indeed show stronger growth. The consensus estimate is that the economy expanded at a 3.1 percent annual rate to start the year.

On one level that might look like a number to celebrate. Three percent growth would, of course, be lot better than the 1.5 to 2 percent that has been the norm through the last four years of sluggish recovery. But the reality is that if the GDP report matches what analysts are expecting Friday morning, it will be a sign of how far the economy has to go, not how far it has come.

In many ways, the first quarter is shaping up to be merely the flip side of that unusually weak last report, not an acceleration. The most dramatic example is inventories. Businesses reduced their inventories by $47 billion in the fourth quarter, subtracting 1.5 percentage points from GDP. The forecasting firm Macroeconomic Advisers expects that inventories will have risen by $48 billion in the first, almost precisely reversing the drop.

But beyond the simple math of inventory swings, some of the core parts of the economy needed to power a robust recovery are, if the forecasters are right, showing all the signs of the same tepid expansion.

After a terrible report on durable goods orders for March, it appears that business spending on equipment and software grew at an unimpressive 3 percent annual rate in the first quarter, according to Macroeconomic Advisers’ forecast. That is a far below the double-digit percentage gains that had been the norm in the earlier phase of the recovery (and the 11.8 percent gain of the final months of 2012). Things look even worse on business structures (office buildings, malls, factories), which the firm estimates fell at a 6 percent annual rate.

It is almost a cliche at this point to say that housing is poised to fuel the U.S. recovery this year. But while there are plenty of indicators pointing to a nice little expansion in the housing sector, we can't necessarily depend on its strength to drive the overall economy. The residential investment sector contracted so much during the recession that it now makes up a minuscule portion of GDP — about 2.5 percent, down from 6 percent at the peak of the housing boom and a longer-term average of 4 percent.

That means that even what seem like large percentage gains in homebuilding activity only have minor effects on overall growth. In the fourth quarter, residential investment rose at a 17.6 percent annual rate, but that was only enough to contribute 0.4 percentage points to overall growth. The bump is likely to have actually shrunk in the first quarter, based on data on home construction and sales numbers so far.

Then there’s the largest single component of GDP: personal consumption spending. If a genuine, rapid recovery is to come, this sector has to be a big part of it. Rising home and stock market prices and progress in reducing household debt  should give Americans more room to spend. But the first-quarter number will be a little hard to parse because of distortions.

First, incomes got a boost at the end of 2012 as companies paid extra-large dividends in advance of January tax increases. Then, on Jan. 1, payroll taxes rose, reducing most workers’ after-tax income by 2 percent. How that all shook out in terms of spending is hard to predict -- retail sales numbers were solid in January and February but weak in March.  But it will make interpreting the numbers in Friday's report more uncertain than usual.

Think of it all this way: If you average the 0.4 percent growth of the fourth quarter with the forecast 3 percent in the first, you get a 1.7 percent annual rate of growth over the last six months. That's very much along the lines of our economic growth rate for the last four years, a grinding, gradual expansion that doesn’t make up the ground lost during the recession.

If Friday morning's GDP report matches forecasts, it will mean that we’re just having more of the same, even if the initial headlines look a good deal rosier.

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Neil Irwin | April 25, 2013