According to today’s data release from the Bureau of Economic Analysis (BEA), gross domestic product (GDP)—the broadest measure of the nation’s economic activity—contracted at an annualized rate of 0.1 percent in the fourth quarter of 2012. This is down from the 3.1 percent growth rate of the previous quarter and from the 2.1 percent average growth rate that characterized the first three quarters of 2012.
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The contraction was driven by multiple factors that should prove largely transitory; it is unlikely that today’s report signals a return to outright recession. For example, private inventory investment decelerated rapidly, subtracting 1.3 percentage points from the quarter’s growth rate, and national defense spending fell at a 22.2 percent rate, subtracting another 1.3 percentage points from the quarter’s overall growth rate. However, both are notably volatile components of overall GDP, and there is little reason to believe that either will continue to drag as heavily on future quarters’ growth.
However, other areas of weakness in today’s report show an economy still struggling to mount a full recovery. Exports fell at a 5.7 percent rate for the quarter, while state and local government spending contracted for the 12th time in the last 13 quarters.
One area of strength in today’s report was business investment in equipment and software, which rose at a 12.4 percent rate and contributed 0.9 percentage points to the overall growth rate.
Personal consumption expenditures (PCE) rose at a 2.2 percent rate, largely in line with growth since the official end of the Great Recession in the second quarter of 2009, and up slightly from the 1.6 percent growth rate registered in the third quarter of 2012.
Disposable income was boosted significantly through increased dividends, as many firms sought to pay special or accelerated dividends before 2012 ended, in anticipation of higher tax rates in 2013.
It’s important to note something that the data on defense spending and private equipment and software investment highlight clearly: The effect of fiscal contraction (i.e., the “fiscal cliff”) on growth does not work through predictable changes in business behavior based on “uncertainty” or psychology. Instead, it works simply through spending. So, when federal spending falls (as it did in the last quarter of 2012), GDP growth slows. And in today’s still-depressed economy, this falling federal spending is almost certainly not neutralized by private spending elsewhere. Too many economic observers instead act as if the primary channel through which fiscal policy affects the economy is through the state-of-mind of business owners, which is why many have labeled the strength of indicators such as equipment and software investment, or last week’s strong numbers on durable goods orders, a “surprise” given the “uncertainty” created by the fiscal cliff negotiations. There was no reason to be surprised, as the drag from fiscal policy simply does not work through psychology; it works through spending.
A key measure of inflationary pressure decelerated for the third straight quarter. The “market-based” price index for core PCE (excluding volatile food and energy components) rose by just 1.6 percent relative to the last quarter of 2011. For 13 of the 15 quarters since the Great Recession ended, this inflation measure has been below the conservative 2 percent rate that policymakers often identify as a target. These very low inflation pressures constitute key evidence that the economy is still performing far below potential.
The gap between actual and potential economic performance is shown another way in the figure below. It charts the ratio of actual GDP to potential GDP. (Potential GDP estimates how much output could have been produced had all productive resources—mostly labor and capital equipment—been fully utilized.) The “output gap” between actual and potential GDP reached a peak of 7.5 percent at the recession’s trough, but still remains over 6 percent even five years after the Great Recession began. In dollar terms, this means the economy forfeited well over $900 billion in 2012 because of resources that were idled by the Great Recession and have failed to recover.
