Fourth Quarter Nominal GDP Growth Rate Revised Upward to 3.8%

The Commerce Department Friday revised upward its calculation of the annualized growth rate of the U.S. economy, reporting that GDP rose at an annualized rate of 3.8 percent during the period from October to December of 2004. This revision was widely reported in the news media and was interpreted as showing a robust economy for the most recent quarter for which data is available. What media outlets and the Commerce Department failed to point out, however, was that this growth rate included the effects of inflation during the period, meaning that the economy grew significantly less once that effect is factored out.

By not removing the component of growth that is caused merely by prices of goods and services going up due to inflation, the economy's strength is overstated, since inflation represents no actual increase in the value of goods and services produced by an economy; instead, inflation merely represents the economy's adjustment of real prices to the excess supply of money over what the economy actually needs to function properly.

Inflation is typically measured by three standard methods, along with several adjustments with two of those methods. The consumer price index (CPI) measures the effect of rising prices on a market basket of goods that a typical American household would purchase; and the producer price index (PPI) measures the effect of rising prices on a market basket of goods at the wholesale level.

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The "market basket of goods" is a collection of goods and services that approximates most of what a typical household or business would buy. The total cost of this hypothetical shopping cart is calculated each month to track the changes in the overall cost of living.

A variation on each of these is called the "core," which does not include food and energy price level changes. This core rate is considered useful for short-term analyses because food and energy prices tend to swing quite a bit both up and down from week to week and even from month to month. However, over a longer period of time, the effects of price level changes in these sectors should be included, in part because of their significant impact on the overall budgets of households and business, and in part because the short-period swings tend to smooth one another out, allowing underlying trends in the price levels of food and energy to show themselves. The Chairman of the Federal Reserve Board, Alan Greenspan, has indicated in the past that he favors looking at core rates, which indicates that he does not consider the food and energy price changes facing consumers and businesses as particularly worthy of concern. Whether or not he understands the large amount of consumer and business budgets that are used to pay for items from these sectors is not entirely evident, however.

Along with the CPI and the PPI as means of measuring the extent of inflation affecting an economy, a third measure is the GDP deflator, which essentially measures the extent to which one year's GDP has risen over the previous year's as a result of relative price changes. Some economists favor the GDP deflator over the CPI and the PPI because the deflator doesn't rely on a perhaps arbitrary "market basket" of goods and services to calculate inflation; instead, it looks merely at the overall Gross Domestic Product of one year relative to the Gross Domestic Product of the previous year. The main drawback to the deflator is that, by not at least attempting to see what price changes are doing to some representative market basket of goods, it ignores the reality that consumers and businesses actually do spend money on goods and services, not on some broad structure far beyond their decision-making control like the entire economy.

Regardless of what measure of inflation is used, the basic calculation of real growth is quite simple: the rate of inflation for a given period is deducted from the nominal rate of growth for that period.

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The term "nominal" means that the effect of inflation is included. Nominal values are what households and businesses actually see. So-called "real" values are evident only after inflation is subtracted out.

What remains is how much real growth occurred during the period. As a simple example, suppose a worker gets a five percent raise in pay, while inflation is running at four percent. This means that the worker really received only a one percent pay raise in real terms, since the other four percent of his raise does nothing but keep his ability to pay his usual bills right where it was before. In other words, the four percent part of his pay raise does nothing but compensate him for the four percent erosion of his raw purchasing power.

And so it is with an economy in the large. By reporting a nominal growth rate of 3.8 percent, the observer does not know how much of that growth rate was merely the result of prices rising without any real compensation of the economy for more goods and services and for more value in those goods and services.

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The consumer price index measures inflation at the retail level; the producer price index measures inflation at the wholesale level.

But as far as what inflation rate for the last quarter of 2004 to subtract from the nominal growth rate in order to obtain the real growth rate over the period, that could be open to some disagreement. By using the CPI or the PPI, the somewhat arbitrary nature of the market basket of goods could distort the true picture of what inflation was doing at the macroeconomic scale. Moreover, choosing the CPI ignores effects of price level changes at the producer level that might not get passed along—at least, not right away—to consumers. But by using the PPI, the impact on households of rising price levels is ignored, and households constitute almost two-thirds of all economic activity in the U.S. By using the GDP deflator, although there is no issue of whether wholesale or retail prices are being considered, the underlying effect on the actual shopping cart full of goods and services for which people and companies pay becomes irrelevant, even though what that shopping cart full of items costs is very real and very relevant to the people and businesses that must budget and spend actual money.

According to the Bureau of Labor Statistics' Consumer Price Index Website, the consumer price index for the fourth quarter of 2004 indicated an annualized inflation rate during that period of 1.1 percent. Deducting this from a nominal growth rate of 3.8 percent for the same period would mean that the real annualized growth rate of GDP for the fourth quarter was 2.7 percent.

According to the Bureau of Labor Statistics' Producer Price Index Website, the producer price index (at the finished goods stage of production) for the fourth quarter of 2004 indicated an annualized inflation rate during that period of 1.6 percent. Deducting this from a nominal growth rate of 3.8 percent for the same period would mean that the real annualized growth rate of GDP for the fourth quarter was 2.2 percent.

And finally, according to a recent Wachovia report, the GDP deflator for the fourth quarter of 2004 indicated an annualized inflation rate during that period of 1.5 percent. Deducting this from a nominal growth rate of 3.8 percent for the same period would mean that the real annualized growth rate of GDP for the fourth quarter was 2.3 percent.

Although these three estimates of the real annualized growth rate of the U.S. economy vary somewhat, they all point to an economy whose real growth of value in its total output was considerably less than what the Commerce Department reported and the mainstream news media repeated without critical review. While the Bush Administration and the mainstream news media may attempt to gloss over the fundamental weakness the United States economy was displaying by the end of last year, it is worth noting that a more accurate presentation of the reality of lackluster growth of the economy would allow both lawmakers and citizens—and possibly even the Federal Reserve, as well—to have a better understanding of the challenges that lie ahead for an economy increasingly suffering from job losses, rising interest rates, and eroding confidence in the dollar overseas.