Friday, December 26, 2008

Could Real GDP Rise in Q4?

I think that the forecasts of real GDP growth rates Q3-Q4 of -5 to -6 percent (annualized) are too pessimistic. However, might real GDP actually grow Q3-Q4?

We have employment and hours numbers for Oct and Nov already saying that aggregate labor hours growth Q3-Q4 (annualized) will be -7 to -8 percent. That means that real GDP growth requires total factor productivity (this is different from hourly productivity I have discussed in previous posts -- TFP is how much GDP would grow if labor were constant) to increase 5 percent or more. That's more than the trend productivity in the recent past, so the odds must be less than 50%.

Productivity growth (for one quarter, at annual rates) has been 5% or more during previous recoveries. It happened two quarters in a row starting 6 quarters after the start of the 1981-82 recession. It happened 4 quarters after the start of the 1990 recession, and again 3 quarters later. It happened 3 times in the year following the start of the 2001 recession. Interestingly, the 2001 recession was a recession with very little quarter-to-quarter productivity decline (this recession has none). This tells me that the odds are not negligible.

Also note that there was a major hurricane and a strike in Q3, which were gone by Q4. This by itself would create a bit of productivity growth.

I am confident that personal income deflated with the CPI will be higher in Q4 than in Q3, given that it is already so much higher in Oct and Nov than it was in Q3. The GDP deflator tends to be less volatile than the CPI, so personal income deflated by the GDP deflator will likely grow less. However, given that Oct and Nov NOMINAL personal income are a bit higher than the Q3 average and that the GDP deflator will fall Q3-Q4 (albeit less sharply than the CPI), it seems that personal income deflated by the GDP deflator will grow Q3-Q4 about 1 percent = 4 percent annualized.

From this perspective, the question is whether GDP could grow one percent (4 percent annualized) less than personal income. The differences between GDP and personal income include depreciation, retained earnings, net factor income paid to foreigners, and bunch of public sector items (plus estimation error in going from monthly to quarterly). Personal income is about 85% of GDP, so the residual between them would have to shrink by 7 percent (= 28 percent annualized) in order for GDP to grow 1 percent less than personal income. This another reason why I see a significant likelihood that real GDP growth Q3-Q4 is closer to real personal income growth, and thereby positive.

My point estimate for real GDP growth Q3 to Q4 is -2.5% (annualized rate). I get this by assuming that TFP follows trend (about 2% annualized; remember that I see that not much is happening with labor demand) and that labor falls 7%. 2 - (7 * labor's share) = -3. Then I add a little because personal income has done surprisingly well in November.

[some hand waving ...] Probability (real GDP Q4 higher than real GDP Q3) = 0.33. Probability (real annualized GDP growth Q3-Q4 < -5%) + .25. That is, the consensus forecasts are too pessimistic, but not impossible.

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