The GDP Deflator Redux

 | Feb 02, 2013 | 1:30 PM EST
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Earlier this week I wrote about the apparent dichotomy in U.S. defense spending in the durable goods vs. gross domestic product reports. It reminds me of the GDP deflator issue that I discussed last year in "Deconstructing Inflation." (I suggest reading that column in conjunction with this, and you may want to refer to the GDP figures (PDF) as well.)

The Implicit Price Deflator (on page 10, table 4, line 30 of the GDP document) show that the Bureau of Economic Analysis used a price deflator of 0.6% for the fourth quarter of 2012 and 2.7%, 1.5%, and 2.2% for quarters three, two and one, respectively. It also shows the same pattern of a sharp decline in the fourth quarter of 2011 vs. the three previous quarters -- which, incidentally, was my reason for writing about this in May.

The IPD accounts for the percentage increase in activity that may be indicative of price changes for a particular product, compared with the quantity of products sold. For example, if 1,000 televisions were sold in the third quarter at an average price of $500 each, and 1,000 TVs were sold in the fourth quarter at an average price of $550, the increase in nominal activity is $50 per television, and that would be reflected as an increase in GDP. The IPD determines how much of the $50 is reflective of an increase in consumption of TVs vs. a change in prices, also called real vs. nominal GDP. The higher the deflator, the lower real GDP, and the lower the deflator, the higher the level of real GDP.

The IPD is not a simple, objective formula that reflects price changes in a straightforward basket of goods. It is a dynamic and subjective process that reflects actions taken by producers and consumers in the real economy. That also means it is open to human interpretation and interference in each calendar quarter.

The idea that political operatives may game government agencies' economic reports is a touchy subject. I discussed this issue about a year and a half ago in the column "Understanding the Revolving Door." The reality is that the GDP report's IPD is a fudge-factor number used after all objective inputs produce a nominal GDP figure, and it can be used to manipulate the real GDP figure. If nominal GDP is low, the IPD can be reduced to ensure that some or even all of the nominal GDP is reflected as real GDP -- and, thus, perhaps fail to show that a contraction in economic activity has occurred.

This column is not about pointing out figures and making accusations, though. It is about learning to take government reports with a grain of salt, specifically the GDP report, as well as understanding what to look for and why.

A more prudent method of calculating the IPD is to apply it on a rolling four- or eight-quarter basis. In that way, investors may not necessarily assume the IPD for each quarter is accurate; instead, we can average the previous quarters in order to produce an IPD and apply it to the current quarter, and adjust the government's conclusions accordingly. In this case, if we applied this logic over the past four quarters, we would have an IPD of 1.75% instead of 0.6%, and annualized real GDP would have contracted 1.3% in the fourth quarter instead of the 0.1% reported.

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