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GDP: The Mother of All Numbers


Gross domestic product. GDP. The acronym may conjure up nightmares of cramming for your Econ 101 final: C+I+G+(X-M). Relax. Think of GDP as the Swiss Army knife of the economic data. It's an all-in-one tool covering all the goods and services produced using labor and capital located in the U.S. The production of cars and computers are counted in GDP; so are bank transactions, dental appointments, a college education, and foreign tourists visiting Disney World. When we discuss real GDP, we are discussing the economy. That's why the GDP data, released by the Commerce Dept.'s Bureau of Economic Analysis (BEA), so critically affects the behavior of investors, Federal Reserve officials, and fiscal policymakers.

Simply put, GDP is the sum of the output of the economy's sectors. Consumer spending, which accounts for two-thirds of the economy, reflects what households and nonprofit institutions spend on goods and services. Investment is what businesses spend on equipment, inventories, and structures, plus residential construction. The government sector includes federal outlays on everything from the military to highway projects, as well as state and local budgets. But public spending does not include checks for Social Security or welfare. Those are counted as personal income spent by consumers. Finally, imports are subtracted from exports to get a trade-balance figure called "net exports." The U.S. has long imported more than it exports, and this number will almost certainly be negative, making it a drag on economic growth.

The BEA uses data from monthly reports and "puts them together in a coherent way that's easy to understand," explains Steve Landefeld, director of the BEA. Monthly retail reports and auto sales are used to estimate part of consumer spending; the manufacturing inventories and sales reports go into business investment; and the international trade reports add up net exports. (At businessweek.com/investor/primer.htm, you can read previous BusinessWeek Investor articles that explain each of these monthly reports.)

The BEA then seasonally adjusts the raw data and totals them up for nominal GDP. Real GDP--that is, after taking out the effects of inflation--is adjusted for price changes using a method called chain-weighting that makes sure the price changes aren't skewed when people substitute a cheaper product.

Wall Street doesn't pay attention to the level of GDP but rather its growth rate. The percentage change is expressed at an annual rate--in other words, how much the economy would grow for a whole year if the quarter's GDP change were repeated for three more quarters.

When a reported growth rate is vastly different from expectations, the market can react strongly. In January, economists expected the GDP report to show the economy, which is officially in recession, had contracted in the fourth quarter, just as it had in the third. Instead, GDP grew at a 0.2% annual rate last quarter. That increase, taken as a sign that the recession was ending, sent the stock market soaring. Then, on Feb. 28, the BEA revised fourth-quarter growth to 1.4%. Stock prices rallied early in the day until Enron worries pulled the market down.

In 2002, economists expect inventories to generate the bulk of GDP growth. Although the sector is quite small, it is extremely volatile. Keep in mind that GDP is designed to measure what has been produced or consumed in any given quarter. So the level of GDP does not include all the inventories on hand (since some of those goods were produced in quarters or even years before), but only how much those inventories have changed in the quarter. If businesses build up their stockpiles, inventory accumulation adds to the level of GDP. If those stockpiles decline, it subtracts from the GDP total.

Accounting for inventories is where GDP math gets a little strange. That's because, in some cases, businesses can draw down inventories and yet add to GDP growth. In fact, that's what economists think is happening right now. Businesses cut their inventories at a $120 billion annual rate in the fourth quarter. This quarter, economists forecast, companies are reducing inventories by only about $60 billion. That slower rate of inventory drawdown is a plus for GDP growth. Indeed, the expected $60 billion difference would add a large 2.5 percentage points to the first quarter's GDP growth.

The BEA takes three passes at GDP. The first release, available on the last Thursday of the month right after the quarter ends, is called the advance report. A month later is the preliminary, which usually includes the BEA's estimate for corporate profits and margins economywide. Near the end of the subsequent quarter is the final report. So on Mar. 28, we'll get the final numbers on the fourth quarter. Yearly and benchmark revisions come at regular intervals for five years. To get the GDP report, log on to www.bea.doc.gov.

Although the GDP release is one of the longest-running government economic reports--it dates to 1929--it is still a work-in-progress as the BEA tries to address some of its flaws. The first problem is one of timing; the quarterly numbers lag behind the monthly reports. "By the time the GDP comes out, it can be a nonevent because we have most of the monthly numbers," says James Paulsen, chief investment officer of Wells Capital Management. That's why the pros use other data to estimate monthly GDP (table). Next, the BEA has little data on the enormous private service sector. Instead, it estimates spending, from medical care to dry cleaning.

Finally, the revisions can rewrite what we thought we knew about the economy, giving bad investment and policy signals. An extreme example took place in early 2000, says Landefeld. The original reports showed an economy surging by 4.8% in the first quarter. But as the BEA gathered more information, real GDP growth was revised down to 2.3%. If we knew the revised growth rate earlier, Landefeld notes, investors "could have rethought their profit expectations and thus their investments." In addition, the Fed might not have kept raising interest rates as late as May, 2000, if it realized the economy was sputtering. "Bad data is a significant problem for economic policy," Landefeld admits.

To correct these failings, the BEA has requested $11 million in additional appropriations for fiscal 2003. The money would be used to move up the release of the trade data and gather real data on the service sector, which will reduce the magnitude of the revisions.

Even with its drawbacks, the GDP report should not be ignored. The best portfolios are ones diversified into a broad swath of industries. And the GDP report is one-stop shopping for information on what's going on just about anywhere in the U.S. economy.

This is the 13th in an occasional series showing how major economic indicators can affect the stock and bond markets. By Kathleen Madigan


Steve Ballmer, Power Forward
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