USA Outlook Update (May 19, 2006): GDP of 3rd Quarter of 2005 to 1st Quarter of 2006 and beyond

In the outlook updates of Jan. 28, and Jan. 21, 2006, the abnormal gyrations of national defense spending have been discussed, and the process to smooth out the gyrations of defense spending has been shown to moderate the gyrations in the growth of real GDP, too. Such a smoothing out process will also affect the growth rate of real GDP of the first quarter of 2006, since the smoothing out process will boost the defense spending in the 4-th quarter of 2005 and thus reduce the growth rate of defense spending from the 4-th quarter of 2005 to the 1st quarter of 2006. In the data of real GDP of the 4-th quarter of 2005 to the 1st quarter of 2006 there is another significant gyration needs to be smoothed out, that is, the gyration in the personal consumption on durable goods. This gyration is mainly caused by the sharp fall of automobile sales in December of 2005 due to the end of discounts, and the bounce back of car sales in January of 2006 due to the resumption of discounts and unseasonably warm weather. To smooth out any component of personal consumption, we need to smooth out inventory accumulation too since falling personal consumption will boost inventory that will add to GDP and cancel the negative effect from falling personal consumption somewhat. With those smoothing out processes, the adjusted growth rates of real GDP become +3.9% for the 3rd quarter of 2005, +2.7% for the 4-th quarter of 2005, and +3.2% for the 1st quarter of 2006 respectively. Those values should be compared with the headline numbers of +4.1% for the 3rd quarter of 2005, +1.7% for the 4-th quarter of 2005, and +4.8% for the 1st quarter of 2006 respectively.

The adjustments discussed in the previous paragraph are all based on the headline numbers, that is, the numbers announced on April 28, 2006. However, the headline numbers themselves will be revised in the next announcement at the end of May. One such sure revision is due to the overestimate of net exports in the announcement of April 28. As discussed in various places throughout this website, the subtraction of imports in GDP reports is done simply to cancel out the error contained in the personal consumption expenditure by counting GDP of foreign countries as US GDP. As imports move up or down, personal consumption expenditure will also move up or down accordingly. Thus increased imports do not mean to be negative to GDP; a subtle point even frequently misunderstood by professional economists. However, two sets of data, personal consumption expenditure and trade balance, are compiled separately and the results come out at different dates, creating an illusion looks like larger net export deficit (means larger trade deficit) is negative to GDP. March personal consumption expenditure was published at the beginning of May, almost at the same time of GDP report for the 1st quarter of 2006. This means that the GDP report has already used the data contained in the report of personal consumption expenditure of March. However, March trade deficit report came out in the second week of May, and this means that GDP compilers must guess what March trade deficit is in their report at the end of April. This time their guess of March trade deficit has been too pessimistic, about 4.5 billion dollars too large. This misjudgment will be corrected in the next GDP report at the end of May, and will boost real GDP growth by 0.5%. Of course, other components of GDP will be revised too, but we expect in general that GDP growth rate of 1st quarter of 2006 will be revised upward. With all those smoothing out processes and the anticipated upward revision in the next report, we only see a slight weakening of GDP growth rate at this juncture. The 2nd quarter real GDP growth rate will probably be weaker due to the gyration in the durable goods consumption, but our smooth-out process will boost it up somewhat. If the final result of real GDP growth rate of the 2nd quarter turns out to be around 3% (after adjustment), then the modest weakening of GDP growth around this juncture as anticipated in earlier discussions will be confirmed. As for the remaining part of 2006, as we said in the updates of Jan.21, 2006 and April 14, 2005, the sub par growth rate of GDP will persist through 2006. This view still holds and many economists are now joining this camp. In 2007 we may see a modest rebound in the growth rate of real GDP as the year proceeds due to the new vigor in the expansion of US trade deficit thanks to the strength of Dollar in the latter half of 2005.

The generally weak Dollar from 2002 through 2004 has stagnated the growth of US trade deficit in capital and consumer goods. The continued rise of trade deficit in 2005 is due to the industrial materials sector that includes the import of crude oil. In other words the strong expansion of US trade deficit in 2005 is mainly due to the higher crude oil price. There are two kinds of stimulative effects from trade deficit; the direct effect as summarized in article 2A and the monetary effect as discussed in Comment 28. The direct stimulative effect comes from trade deficits in capital and consumer goods sector, but not from higher oil price. The monetary effect goes as follows: large trade deficit directly translates into large current account deficit that is equivalent to large foreign capital inflow, i.e. large capital account surplus, since current account deficit must cancel exactly the capital account surplus by definition. Large foreign capital inflow in turn stimulates loan markets and induces US consumers to spend more through borrowing. Ironically even larger trade deficit through higher oil price will contribute to the monetary stimulus, and the strong showing of US real GDP growth in 2005 demonstrates vividly this kind of stimulative effect of trade deficits. However, the oil price has started to moderate around the end of 2005 and the overall US trade deficit has also started to stagnate. Combined with continued sluggish growth of trade deficits in the capital and consumer goods sector, both kinds of stimulative effects from trade deficit will be reduced in 2006 and thus will lead to a sub par growth rate in real GDP.