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September 02, 2008
Does the GDP deflator lie?
Though last week’s report on U.S. gross domestic product (GDP) growth in the second quarter is second-hand news by now, I’ve taken note that Barry Ritholtz’s views on the news has, in particular, continued to rumble through the blogosphere. Barry is not happy with the GDP deflator, and samples approvingly from a Barron’s article by Aaron Abelson:
“GDP, in common parlance, stands for gross domestic product, or the aggregate value of all the goods and services produced on these blessed shores... These days, alas, those initials more typically signify “gross deceptive pap”...
“Comes now the so-called preliminary estimate that claims second-quarter GDP grew by a much more robust 3.3%.
“The key here is the GDP deflator, which purports to adjust GDP for the impact of inflation; it’s a curious calculation in that, contrary to its moniker, it seems designed to do the exact opposite of deflating GDP.
“Thus, according to this accommodating measure (accommodating, that is, if you’re determined to put a good face on a dreary report), inflation grew at an improbably restrained 1.33% in April-June. And maybe it did—but not in the good old U.S. of A. However, obviously more important than accuracy to those doing the calculating is this simple equation: The lower the deflator, the greater the growth of GDP…
“Of course, even by the government’s not entirely extravagant figuring, the consumer price index was up a hefty 8% in the latest quarter. Perhaps the computer that tallies the CPI doesn’t talk to the computer that measures the deflator.”
Strong words, but if you ask me, misguided. Barry actually makes the case against the case in this picture, about which he notes:
“It’s no coincidence that the current situation resembles past ones where oil prices had spiked. Since more than half of the U.S. Crude consumption is imported, the price and quantity go into all GDP calculations as a negative.”
Exactly. Let me provide an elaboration of the spot-on point made at The visible hand in economics blog. For the sake of argument assume that every drop of oil consumed in the United States is imported, and everything imported to the United States is oil. If we leave exports out of the picture for simplicity, we can think of U.S. consumption as consisting of GDP—everything produced in the United States—and imported oil.
Suppose, then, that the price of oil rises precipitously. If both incomes and oil consumption are relatively fixed in the short-run, what would we expect to happen? The answer is more expenditure on imported oil and less spending on everything else. As the demand for domestically produced goods and services falls, so would their prices. (Or more generally, they would rise at a slower than normal pace.) Since domestically produced goods and services by definition constitute GDP, GDP-deflator inflation will be low, while the consumer price index (which would include nonexported GDP plus imports) could well be quite high.
Voila! A simple Econ-101 explanation, with nary an insult hurled at the good folks from the Bureau of Economic Analysis.
That said, there are plenty of reasons to be cautious in interpreting last week’s report. Mark Thoma has a fine roundup of many fine points by many fine bloggers. To that list I’d add comments by Spencer at Angry Bear, William Polley, Lim at The Skeptical Speculator, Ben Leeson at Working Thoughts, Zubin Jelveh and Felix Salmon (both at Portfolio.com), to name a few. But I would delete the suspicion that low GDP-deflator-based inflation suggests shenanigans are afoot.
September 2, 2008 in Data Releases, Inflation | Permalink
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Listed below are links to blogs that reference Does the GDP deflator lie?:
» The GDP Deflator and the Inflation Rate from Economist's View
There is confusion between the GDP deflator and other measures of prices such as the CPI and the PCE deflator. Here's one way to think about it that might help to clear things up. The CPI (or the PCE) attempts [Read More]
Tracked on Sep 3, 2008 7:04:58 PM
» Taking a Closer look at Other 3 % GDPs from The Big Picture
Over the years, I have criticized a variety of official data points as misleading: Consumer Price Index (CPI) for woefully understating price increases, Non Farm Payrolls (NFP) due to the Birth/Death Adjustment, Core Inflation for omitting anything goi... [Read More]
Tracked on Sep 4, 2008 7:44:13 AM
» Borrowing future growth from Newshoggers.com
By Fester: Today's employment and unemployment numbers were ugly. The unemployment rate went to 6.1%, another 84,000 jobs were cut in the initial August estimates after the July estimate was increased to a job loss of 100,000 jobs, and wage [Read More]
Tracked on Sep 5, 2008 3:21:21 PM
Comments
Posted by:
Stephen Gordon |
September 02, 2008 at 06:31 PM
>Voila! A simple Econ-101 explanation
Aha! that means that is has no relation to the real world, like most "simple Econ-101 explanations" ...
Posted by:
Marcello |
September 02, 2008 at 08:33 PM
OK, I follow your argument. But it still seems too low. It is much lower than the core inflation numbers being reported which strip out food and energy. Add food back in and I bet it is north of 3%. What's the explanation for this?
Posted by:
pclema |
September 02, 2008 at 08:35 PM
Having seen the discussion on Barry Ritholtz’s series of posts, I agree with your conclusion here. You’ve described a scenario in which import inflation results in downward pricing pressure on domestic output and the deflator. A variation on this scenario is one in which import inflation at the margin adds to the current account deficit, with no change in the pricing of domestic value added or in domestic income, and no net effect on the deflator. This would still explain a deflator level that was persistently lower than an inflation rate that incorporated import prices.
These scenarios are variations on the same relative pricing effect. In either case, one can compare the difference between the deflator and some broader measure of consumer prices, such as the CPI, the latter which would include the price effect of embedded and directly purchased imports. The difference between the two is the degree to which there is downward pricing pressure on the deflator itself. Either way, the spread between the deflator and the more import inclusive measure of inflation widens.
The GDP deflator calculates price changes for domestic production, while broader inflation measures such as CPI capture domestic consumption. Both are sensitive to the treatment of imports and exports. The most evident difficulty in interpreting the deflator versus alternative measures has to do with these international elements.
A common objection is that the GDP deflator, because of its currently depressed level, doesn’t impress the “man (or woman) on the street”, who is seeing and experiencing a much higher headline CPI number.
The further inference is that the number or “the model” must be wrong. Add to this protest the other issues that are perennial fodder for the inflation measurement debate, and the discussion becomes a bit of a mess. And finally, for additional density, add conspiracy notions to the mix.
The irony is that the GDP deflator shouldn’t be that interesting to the typical consumer, who won’t be so curious about the price of goods that the US is selling overseas. But that person, if she does pay attention to this number, should know it excludes changes in import prices as embedded in final purchases. At the same time, she would want to know if such import price changes are being passed on, absorbed, or accentuated by the final product pricing of domestic vendors.
The GDP deflator is a complicated measure, in that it includes foreign exposure to US generated inflation, while excluding direct US exposure to foreign generated inflation. The typical consumer (or blogger), should probably approach its interpretation carefully, with this in mind.
At the same time, it should help the average consumer to know that alternative measures of inflation are available that are more indicative of price behaviour within their immediate experience. And if they are interested in the GDP deflator, they should read up on it at professional economic sites such as this, knowing that the explanation will be measured and correct.
Posted by:
JKH |
September 02, 2008 at 10:34 PM
I just had a very similar post about GDP chain deflator in my blog last week. You can check if you want, link is in my name.
Posted by:
Andy Bebut |
September 02, 2008 at 11:53 PM
Lie is the wrong word -- my question is, does GDP present an accurate portrayal of economic reality?
The short answer last quarter was no.
My take is that 3.3% in Q2 is very misleading -- and the guilty culprit is the deflator, a misnomer last quarter, as it served to INFLATE GDP data.
Note that this is not a conspiracy theory, but rather a critique of a model that does a mediocre job in portraying the economy . . .
Posted by:
Barry Ritholtz |
September 03, 2008 at 06:53 AM
"...As the demand for domestically produced goods and services falls, so would their prices. (Or more generally, they would rise at a slower than normal pace.)..."
really?
that´s the same old fed rhetoric that justified the wave of rate cuts.
over the last year demand DID fall and prices DID rise as companies pass higher costs to protect their margins.
so far the text book of economics didn´t work.
Posted by:
GreenAB |
September 03, 2008 at 07:33 AM
Is it not simple quantitative analysis? The import deflator of -4.56% overwhelmed the PCE, Investment, Export and Government deflators of 2.93%, 0.11%, 1.37% and 0.98%, respectively.
BEA Table 1.1.8
Posted by:
marmico |
September 03, 2008 at 08:40 AM
Better to look at the deflator for Final Sales to Domestic Purchasers. This measures what people (and businesses) BUY, not what they produce. For 2Q08 it ran 4.3%. Makes one wonder about 2% Fed Funds and Treasuries under 5%!
Posted by:
Doug |
September 03, 2008 at 10:03 AM
I love economics, and that's why I read posts like this. But aren't Econ 101 explanations (deliberately) grossly simplified? I think the real world flaw in this explanation is the assumption that oil is solely a consumer ready commodity. Doesn't the rise in the price of imported oil affect domestically produced goods because oil is an input? Shouldn't the deflator be higher to account for this fact? If we're using nominal prices for output, I don't understand how the rise in a critical input like oil shouldn't make the deflator pretty high right now. This is not a conspiracy theory but goes to Barry's point that the headline number is ridiculous in the context of the real world we all inhabit.
Posted by:
anon |
September 03, 2008 at 12:46 PM
I just posted on this. Wish I had seen this yesterday...
Posted by:
David Merkel |
September 03, 2008 at 02:24 PM
The other dimension to this is that the GDP deflator also includes the price of residential investment, which has been falling in line with the OFHEO house price index.
In fact, there's a good argument to be made that the GDP deflator overstated inflation in Q2 because the BEA insists on basing that residential investment deflator on the OFHEO index rather than the Case-Shiller index. The latter suggests house prices have been falling much more sharply. If the BEA used the Case-Shiller index instead, the GDP deflator might have turned out to be negative.
Posted by:
Anon |
September 03, 2008 at 04:21 PM
The average person doesn't and shouldn't care about the GDP, nor should the press or any organization push it as a measure of economic health. The GDP can rise by 10% and it wouldn't mean a darn thing to someone buying milk at $5.50 a gallon. Real world economics is a whole different ball game. You have to look at prices on the streets.
Posted by:
John Brock |
September 03, 2008 at 04:56 PM
it would be more proper to state that if the price of one good (like oil) increases sharply, due to for instance, a supply shortage, and the money supply stays stable at the same time, then prices for other goods elsewhere in the economy would have to fall to balance the price rise in oil out. unfortunately this simple model doesn't work in the real world either, because the money supply is anything but stable. what is commonly referred to as 'inflation' is better called 'rising prices' as it is really only the effect of inflation (inflation of money and credit), and this effect tends to arrive with a considerable lag, as newly printed money is obviously not received by all participants in the economy at the same time. it feels downright odd to have to point this out, but inflation is a monetary phenomenon. in the meantime, as regards GDP , it is a pretty useless number for a great many reasons. Sean Corrigan wrote (a by now somewhat dated, but still pertinent) article on the 'anatomy of growth' that looks at this in some detail. link:
http://mises.org/story/1491
Posted by:
pater tenebrarum |
September 03, 2008 at 10:37 PM
Is it fair to extrapolate from this argument that U.S. companies have virtually no pricing power for domestically produced goods and services? It seems to me that this is a recipe for razor thin domestic operating margins. Are U.S. companies generally applying the airline model, whereby companies are trying to make up for negative margins through volume growth? Uh oh.
Posted by:
Adam Butler |
September 04, 2008 at 08:28 AM
That was a technical explanation of how it is calculated. It doesn't change the fact that the number does not reflect how strong or weak the economy is. It is simply not credible to assert 3+% economic growth when employment and real wages are falling an corporate profits at the same time is plummeting.
Posted by:
Stefan Karlsson |
September 04, 2008 at 09:49 AM
Hmmm, Here's an interesting observation:
“The current crisis has revealed fundamental shortcomings in the prevailing credit arrangement,” exposing weaknesses that will “require significant institutional change in both the public and the private sectors,” said Terrence Checki, executive vice president of the New York Federal Reserve."
Posted by:
bailey |
September 04, 2008 at 10:03 AM
Federal Reserve Bank of San Francisco President Janet Yellen said in a speech today that the economy's acceleration to a 3.3 percent growth rate in Q2-08 "is likely to prove ephemeral". Indeed, years from now we will look back at this Q2-08 GDP datapoint as an outlier to what is commonly inferred by GDP. The reality of the revised report is that Net Export contributed 3.1% of the 3.3% Q2 GDP number. The real growth rate of export was revised to contribute 1.65% from 1.16%, and the real growth rate of import was revised downward so as to contribute 1.45% from 1.26%. As such, the large impact net export had on the final GDP number reveals substantial weakness in domestic demand and hence the comments provided by others responding to this topic. The question Dave, Janet and the others at the Fed have to be asking themselves is if this export effect on GDP is likely to continue. The answer lies in one's belief about the strength of the largest US export economies, coupled with one's belief about the current rally in the US dollar. If the dollar rally is a temporary aberration, and the economies of Canada, Europe and Mexico are believed to escape the world's current economic malaise, then Q2 GDP won't seem so odd. However, if the dollar rally is sustained and the G7 economies tip into recession, this Q2 GDP number will soon be forgotten. Ms. Yellen went on today to say, "My forecast is for sluggish growth in the second half of this year with substantial downside risks." At this point, that seems a rational bet.
Posted by:
Ken |
September 04, 2008 at 05:52 PM
Even more pronounced difference happened in Slovakia in 4q07, when deflator was negative, even though the consumer prices rose by more than 4%. The nominal GDP growth was thus at around 11%, and real at 14.3% :)
Posted by:
Michal Lehuta |
September 05, 2008 at 10:32 AM
Your mindframe is still based on closed systems. That doesn't apply any more and leads to the faulty logic you once again show here.
Prices do not magically fall or fail to rise, because internal demand is faltering. Maybe the price in the barbershop. But nearly everything else today is tradeable, including services of course.
Prices of tradeables are not determined by internal demand. This is why your explanation is just horrific economics.Actually it's a shame.
Posted by:
jboss |
September 05, 2008 at 10:46 AM
The contentious issue was whether Q2 real GDP growth could be explained rationally. The debate was between those who could explain it rationally, and those who believe its a failure in "the model", due to the low level of the GDP deflator. My view is that the rational explainers win the debate, as presented here.
An entirely separate issue is whether Q2 real growth is sustainable. This is addressed in the Yellin speech.
The first issue has nothing to do with second.
But I fully expect that those who have rejected the Q2 number on the basis of the first argument will come back in Q3 and claim victory using evidence on the second.
Posted by:
anon |
September 05, 2008 at 10:47 AM
With regard to Anon's comment: According to Wikipedia (not the final authority on such things, but certainly a reasonable source for general interpretation in this context), "GDP is widely used by economists to gauge the health of an economy". If the debate in this topic is over the rationality of the Q2 GDP explanation, and as Anon has done, we accept that explanation as rational, then we must also conclude the Q2 GDP value as being indicative of the health of the economy in Q2 (based on the Wikipedia definition). So which of the following statements is most true for you:
1. I accept the GDP model works perfectly providing me with an exceptional insight into the health of the economy in Q2, and therefore will base by business investment decisions going forward on the fact that the trend in economic growth turned the corner in Q2.
or...
2. Q2 GDP is a number that I find to be an outlier one-time event, particularly in light of the weak GDI and it provides little insight into the overall health of the economy. As such, I don't necessarily find the GDP model to be broken, but I will likely not alter my business investment decisions based upon this single number.
Distilled: a meaningful debate should be over if the Q2 GDP number the model produced was valuable in providing us with a guage of the economy's health and will alter business investment as a trend altering event going forward; or if in retrospect we will soon come to view the Q2 GDP number the model produced as an outlier.
Posted by:
Ken |
September 05, 2008 at 05:05 PM
Re: Ken’s comment from September 05, 2008 at 05:05 PM
Proposing a “meaningful debate” is fair enough, but the main post addresses a false line of argument that rejects the validity of the GDP result. This false argument impedes a more meaningful economic analysis of GDP results. The contrast is noted in the final paragraph of the post.
With respect to the questions posed, business decisions shouldn’t be based on a retrospective view of the economy. One needs to look deeper than an ex post quarterly GDP measure to investigate the probable path for future readings. The post concludes by pointing to forward looking analyses beyond the Q2 result. Most acknowledge that most of the growth was due to net exports, and question the sustainability of that factor.
And the accuracy of a particular GDP reading shouldn’t be confused with a legitimate difference between trend and volatility. Conversely, volatility doesn’t prove measurement inaccuracy.
This brings us back to the blogging case made against the veracity of Q2 GDP growth. The most aggressive version goes something like this:
a) The high level of the Q2 import deflator has artificially depressed the GDP deflator
b) The low level of the GDP deflator is not representative of “reality”
c) The low level of the GDP deflator has artificially boosted Q2 real GDP
d) Q2 real GDP is not representative of “reality”
Each of these is wrong. The first contradicts the factual definitions that determine the various GDP equations. The second confuses the deflator with competing consumption oriented measures such as CPI. The third further ignores definitional relationships. And the fourth is a summary conclusion supported by the additional general evidence of “gut feel”.
These erroneous contentions fail to consider Q2 net exports, which provided the largest sector contribution to Q2 GDP growth. Net exports constitute the least observable GDP component from the perspective of those who focus on domestic consumption/inflation, while ignoring the definition of GDP and the GDP deflator.
The difference between GDP and GDI is a valid measurement issue.
None of this means that Q2 GDP won’t be revised lower. Nor does it mean that Q3 GDP can’t be lower, or that import inflation can’t be lower, or that the deflator can’t be higher. To suggest that Q2 real GDP is not indicative of a trend is entirely reasonable. But it is a fraudulent distortion to suggest it is not so because the low reading on the GDP deflator has somehow “inflated” real GDP.
(Janet Yellen’s recent speech, as excerpted by Ken above, includes the reasonable prognosis of weaker GDP following the Q2 result. But in no way does it contradict the Q2 measure per se.)
Posted by:
anon |
September 08, 2008 at 06:19 AM
Re: Anon's 9/8/2008 6:19 a.m. comment
We are debating two seperate issues. The first is the validity of the measurement. For this I have no disagreement with what Anon or Dave have argued. They are in my view, absolutely correct. The subject of this post I didn't believe was to limit the debate to simply the validity of the measurement, but rather more to the point was the issue of people being so dumbfounded by the value that they were willing to believe fraud was the source. To debate the measurement is one debate. To debate the extraordinary implication of the value is another. I was addressing the later rather than the former. For further reading on this part of the debate, Caroline Baum has a great article on Bloomberg this morning titled, "Output Without Income Is Like a 'Virgin Birth'. It addresses the lack of GDI in the face of roaring GDP. She sources a study by Fed economist Jeremy Nalewaik that suggests "real time GDI has done a substantially better job recognizing the start of the last several recessions than has real time GDP". While perhaps others are not so inclined, there are times when I believe GDP does not give us sound information about the health of the economy. Q2-08 was one of those times.
Posted by:
Ken |
September 08, 2008 at 12:09 PM
Re: Ken’s 9/8/2008 12:09 p.m. comment
I don’t disagree. The number may well be questionable for several reasons. The GDI disconnect is a legitimate source of concern. The sustainability of net export growth is another. Inventing erroneous algebraic inferences within the GDP equations is not.
Posted by:
anon |
September 09, 2008 at 07:06 AM
What I like about this explanation is that it also explains what's going on with the puzzle of slow GDP growth in Canada. The story is the same, but with the signs reversed.