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Economy in Brief

Q1 GDP: Something Missing?
by Joseph G. Carson (  May 1, 2018

The initial estimate of 2.3% growth in Q1 real GDP by the Bureau of Economic Analysis (BEA) was only slightly above the consensus estimate of 2%, and probably will convince policymakers to stay on the gradual course of policy normalization at the upcoming two-day Federal Open Market Committee (FOMC) meeting on May 1-2.Yet, the details of the report indicate that there is "something missing", and the missing details have a lot to say about the underlying trends in the economy with important implications for monetary policy.

The initial GDP report does not provide a complete estimate of the income side (Gross Domestic Income) of the GDP accounts, as there is not enough data to provide an official estimate on corporate profits. However, one can get a guesstimate or an implied estimate of operating profits based on the data provided by the BEA.

According to my calculations, the initial GDP report suggests first quarter operating profits rose about 4% over the comparable quarter one year ago. That seems awfully low. In fact, the April 27 earnings scorecard of FACTSET shows that with 53% of the S&P reporting the blended earnings (which is a compilation of reported earnings plus the consensus estimates for the remaining companies) for Q1 show a gain of 23.2% from year ago levels. To be fair, Q1 2018 reported earnings are not strictly comparable to Q1 2017 given the change in tax law. Yet, even if operating earnings, excluding the benefits of tax law, are up half as much as what the initial reports suggest that is far above what is implied in the initial report of Q1 GDP.

Why is this important? A 2010 paper titled “The Income and Expenditure Side of US Output Growth, by Mr. Jeremy J. Nalewaik, a research staffer at the Federal Reserve, found that the income side of the GDP accounts “is the better predictor of a wide variety business cycle indicators that should be correlated with true output growth” and that income side predicts revisions to GDP (or the product side).

Revisions to GDP are common, and sometimes the revisions are so large that initial estimates paint a misleading picture of the underlying trends in the economy.

For example, Q1 2015 was initially reported at 0.2% annualized, creating the impression that the economy hit stall speed, and a number of analysts and policymakers attributed the slowdown to a variety of transitory factors. And, the picture on the Q1 economy’s performance got even worse with the release of more data as the next two revisions showed outright contractions of 0.7% and 0.2%, respectively.

BEA has subsequently revised the data and Q1 2015 GDP now shows a gain of 3.2% annualized, one of the largest upward revisions on record. A senior official at BEA told me that there were several problems, including the translation of the scale of consumer purchases from warehouses and supercenters and incorrect sales figures on vehicle sales. Yet, there were substantial upward revisions to business investment and residential investment as well.

It’s counterfactual to say that the Federal Reserve would have acted differently with more accurate GDP data but it is important to note that at the March 2015 FOMC meeting the Fed Chair Ms. Janet Yellen indicated that the Fed was inclined to raise the official target on the federal funds rate at the June FOMC meeting. However, the weak Q1 GDP figures resulted in policymakers at the June FOMC meeting lowering full year 2015 GDP estimates by one-half percentage points from their March projections, and Ms.Yellen stating that conditions for raising the target on the federal funds rate had not been met.

Once again the FOMC faces another data test. The Q1 GDP paints a picture of an economy growing, not too fast and not too slow. Yet, other data, including Q1 corporate earnings reports, business surveys (and the prices paid components) along with labor market data and compensation surveys show an economy expanding relatively fast, with wage and pipeline price pressures. The FOMC would be well advised to begin to move forward their official rate hikes in order to “strike a balance between avoiding an overheating economy and bringing PCE inflation to 2 percent on a sustained basis” as the Fed Chair Mr. Powell stated in his congressional testimony in February.

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