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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:

Consumer Price Index Year-Over-Year % Change

“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

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.

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

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