Of GDP Growth and Deflators: Smoke and Mirrors?

The Bureau of Economic Analysis (BEA) kept its estimate of the annualized growth rate of 1Q2011 gross domestic product (GDP) essentially unchanged at 1.8 percent, but shifted some components’ contributions around. For example, personal consumption expenditures (PCE) were nearly 0.4 percent weaker than previously reported while private domestic investment (PDI) was stronger by about the same amount -- thanks to increases in fixed investments and inventory building. Although both exports and imports grew relative to the prior (advance) report, the changes left the contribution of net exports (NetX) to the overall growth rate virtually the same as the original estimate. Government consumption expenditures (GCE) also changed very little.

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Largely ignored among all the ink spilled discussing the importance of declining government expenditures, changes in trade, and consumer spending in causing the drop from 4Q2010’s 3.1 percent growth rate was a huge shift in the GDP deflator used to remove the effects of price inflation from nominal GDP: from a 0.4 percent annualized change in 4Q2010 to 1.9 percent in 1Q2011. That represents a quarter-to-quarter increase of 375 percent in the broadest measure of price inflation across the U.S. economy. The following is admittedly simplistic, but had the 1Q2011 change in the GDP deflator remained at 0.4 percent, the advance GDP would have come in closer to 3.3 percent than the reported 1.8 percent.

We are not complaining, though, because the growth rate also could have been much worse. The Consumer Metrics Institute (CMI) has been observing that changes in the GDP deflator have been unusually small relative to corresponding changes in both the consumer (CPI) and producer (PPI) price indices for the past couple of quarters. Because the GDP deflator corrects for price changes at both the consumer and producer levels, one might expect the change in its value during any given quarter to lie between the concurrent changes in the CPI and PPI. As we show below, that has been true on average but changes in the GDP deflator have often exceeded those boundaries during individual quarters.

To test whether CMI’s contention is true, we computed annualized quarter-to-quarter percentage changes in the GDP deflator, the CPI for urban consumers, and the PPI between 1Q1950 and the present. We then subtracted the quarterly CPI and PPI percentage changes from the corresponding changes in the GDP deflator; the differences were negative when the GDP deflator’s percentage changes were smaller than those of the CPI and/or PPI, and positive when the GDP deflator’s percentage changes were larger than those of the CPI and/or PPI (the nearby table contains an example of these calculations).

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As mentioned above, the average differences between the changes in the GDP deflator and changes in the CPI and/or PPI have been quite small over time (evidenced by the proximity of the symbols to zero during the 1Q1950-to-4Q2009 period in the figure below). However, wide disparities have often occurred during individual quarters (shown by the length of the range bars radiating from the symbols in the figure below). In some recent quarters (e.g., 2Q and 3Q2010) the GDP deflator’s percentage change has essentially equaled that of either the CPI or PPI, but in other cases the differences have been marked. 1Q2011 is a good example of the latter: In less than 4 percent of the quarters since 1Q1950 have the differences between the percentage change in the GDP deflator and the percentage change in the CPI been more negative than in 1Q2011; only once (in 1Q1974) was the difference between the percentage change in the GDP deflator and the percentage change in the PPI more negative. Hence, we conclude CMI’s contention is valid.

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Who cares, you say? Then consider this: Had the 1Q2011 change in the GDP deflator more closely resembled that of the CPI, the BEA’s estimate of growth likely would have been just barely positive; if more like the PPI, the economy would have been shown as contracting.

This issue is equally important during upcoming quarters. What is the probability that changes in the GDP deflator will continue to be so small relative to those of either the CPI or PPI? We think that probability is quite small. So, if changes in the GDP deflator come back into closer alignment with changes in the CPI or PPI and price inflation picks up speed as we expect, reported real growth will disappear under that statistical “double whammy.”