Soaring GDP Won't Stay Quite as Lofty in 2010

• Outsize strength in fourth-quarter GDP exaggerates the underlying recovery story.
• Inventory dynamics will continue to boost growth in the first part of 2010.
• Better final sales should prompt firms to expand investment and hiring later this year.

Real GDP expanded at a rapid 5.7% annualized rate in the fourth quarter, following a 2.2% rise in the third quarter. This was the fastest pace of output growth in almost seven years, yet the temporary nature of the two major drivers—a swing in the inventory cycle and government fiscal supports—raises concern that the pace will not continue into 2010. This concern is valid, but can also be overstated.

Although fiscal support for growth was apparent in the income detail, government spending actually fell in the fourth quarter as modest increases in federal spending were washed out by cutbacks at the state and local government levels. Moreover, while inventory declines slowed substantially last quarter, firms are still destocking, and the gradual strengthening of final sales suggests that by midyear, firms will need to be expanding their inventories. More broadly, the underlying momentum in final sales, jobless claims, and financial market conditions suggests a very low risk that growth will turn anemic early this year.

Unchanged outlook

On balance, the details of the report do not alter our current forecast, which calls for real GDP growth to weaken to around 2% by the middle of the year. Growth will slow to match demand as destocking winds down, but the gradual firming in final sales suggests the transition from recovery to self-sustaining expansion will be successful. Strengthening final demand is a key bridge between improving financial market conditions and a healthier job market.

Much of the acceleration in GDP between the third and fourth quarters reflects a major inventory adjustment that added 3.4 percentage points to growth. Inventories plunged through the first three quarters of last year, but as they became depleted, firms ramped up production. As a result, real private inventories fell at a $33.2 billion pace in the fourth quarter, only about one-fourth as much as in the prior quarter. Although the slower rate at which inventories are being drawn down leaves less room for a boost in 2010, inventory dynamics will continue to add to growth. Firms watch their inventory-to-sales ratios, and the ratio of inventories to final sales of goods and structures fell to a new cycle low in the fourth quarter. As long as sales do not falter, this will lead to more support for production and output.

Capital spending boost

The surprise strength of capital equipment spending, which rose at a 13.3% annualized rate, the most in almost four years, was the primary reason for the acceleration in growth of real final sales from 1.5% to 2.2% last quarter. Fixed investment swung from contracting at a 1.3% pace to expanding at a 3.5% pace. Holding back performance was residential investment, which grew only 5.7% after an 18.9% rise in the third quarter. A big hit to the economy last quarter once again came from business spending on structures, which fell 15.4%, shaving a half of a percentage point off GDP growth.

The other main reason for better final demand was an unexpected narrowing in the trade deficit to $341.1 billion. Both exports and imports grew at a rapid pace last quarter, but on balance, net exports added a half a percentage point to growth. The government assumed in this report that imports fell at year end, which seems unusual to us given such a sharp turn in the inventory cycle. In addition, the gain in exports seems a bit stronger than leads like new export orders might suggest. If we are correct and after the dust settles trade was neutral for growth last quarter, it would lead to a downward revision to GDP to 5% or slightly below.

Inflation at bay

Consumption rose 2%, as expected, and was up 3% excluding motor vehicles, from 1.6% in the third quarter and the strongest growth pace since the first quarter of 2007. The strength in nonauto consumption becomes easier to explain after looking at the fourth quarter income numbers. Real disposable income increased at a 2.1% annual rate after falling 1.4% in the third quarter; nominal disposable income increased at a solid 4.8% pace. The boost to income was spread between private and public sector factors; transfer payments rose and taxes fell, but compensation rose 2.1%, the best turnout in two years. The saving rate was basically steady at 4.6%; rallying financial markets have buoyed household wealth and that may be steadying the saving rate somewhat after the shock of earlier losses altered behavior.

Inflation was kept at bay. Total GDP prices were up at a 0.6% rate in the fourth quarter after rising 0.4% in the third quarter. On a year-ago basis, GDP prices are up 0.7%, the lowest rate since the 1950s. Core consumer prices were up 1.4% on both a quarterly and annual basis. Pipeline pressures are also absent; today's number points to another increase of more than 8% in productivity and sharp drop in unit labor costs. Productivity can be stretched only so far, and continued strong growth will press firms to increase hiring as the year progresses.