GDP Contracts in Q4 2012

Real GDP fell 0.1%, much weaker than the already weak estimates for the fourth quarter. Inventories, government spending and exports all declined. This is likely to be a disappointment for markets and analysts, who expected a meager growth rate below 1.0%. The drop in inventories was mostly due to the residual drop in farm stocks related to last summer’s drought. The drop in government spending was where the real surprise occurred. It was concentrated in defense services, which reflects the pullback from wars in Iraq and Afghanistan  and a sharp drop in research, development and weapons testing. The Bureau of Economic Analysis (BEA) can’t yet estimate the hit from Superstorm Sandy, but there were substantial disruptions and a pick-up in vehicle sales.

The silver lining was solid gains in consumer spending and residential construction. Consumer spending held up well, mostly due to strong vehicle sales. Insurance claims on vehicles damaged by Sandy were among the first to be paid out. Investment in new equipment rebounded after contracting over the summer as residential investment accelerated. Multi-family home construction was the primary accelerant.

Pricing pressures continued to recede. The price index for gross domestic purchases rose a modest 1.3%, 0.1% behind the already tepid pace of the third quarter. This is a flash point for doves at the Federal Reserve who are concerned that inflation is a bit cool and a reflection of ongoing weakness in the labor market.

Separately, current-dollar personal incomes surged a whopping $256 billion in the fourth quarter, more than three times the pace of the third quarter. Many firms accelerated pay to avoid their high-salaried workers paying higher taxes in 2013. We also saw special dividends paid out by companies to avoid tax changes. Along with expiring tax cuts and some actual increases in tax rates, this will result in a large drop in personal incomes in the first quarter.

Bottom Line: Special factors clearly exacerbated the weakness that we saw in the fourth quarter; we should see some bounce back in overall growth, now that those factors have abated and are working in the other direction. Last summer’s drought will no longer be a drag on inventories, while damages created by Sandy are beginning to be repaired. The economy is not exactly chugging along. We still face ongoing uncertainty about fiscal policy while the risks of a sequestration are rising. Fiscal challenges will not be resolved overnight, nor will Europe swing back to strong recovery anytime soon. But gains in the labor and housing markets will continue to be gradual and steady, adding to consumption and construction activity.

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