How Worrying is the Q1 GDP Decline?
Getting into the guts of net exports, the statistical discrepancy, and more.
American businesses and workers produced 0.36% fewer goods and services in January-March 2022 than they did in October-December 2021 on a seasonally-adjusted basis.1 That’s the first quarterly decline since the initial months of the pandemic.
Federal Reserve officials are unworried, however, because domestic final demand net of inflation rose by 0.66%. That’s the fastest quarterly rate since 2021Q2. As Chairman Jerome Powell noted in the introduction to his postmeeting press conference on Wednesday:
Underlying momentum remains strong, however, as the decline largely reflected swings in inventories and net exports, two volatile categories whose movements last quarter likely carry little signal for future growth. Indeed, household spending and business fixed investment continued to expand briskly.
The disconnect between GDP and domestic final demand could be a fluke that will disappear with data revisions. In fact, there are some strange puzzles buried in the latest numbers. One possible explanation is that business investment is being undercounted.
In this note I will focus on three topics, in increasing order of importance:
The slowdown in inventory accumulation
The plunge in net exports
The implied collapse in corporate profitability (and/or the implied surge in the statistical discrepancy)
Inventories and GDP
As is implied by the name, Gross Domestic Product measures how much is produced within a given area over a given time period. But not all production is used immediately, so when businesses produce more than end users want at any point in time, the surplus ends up getting stored as inventories.2
However, nobody wants to hold too much in inventories, because inventories are (generally) dead weight on the balance sheet. Periods of robust inventory accumulation are often followed by periods of either slower inventory growth or outright inventory liquidation.
On the other hand, if demand is extremely high relative to production, inventories will get drawn down as businesses race to catch up. And just as it’s considered wasteful to hold too much in inventories, there are also levels of inventories that are considered too low—and that will prompt restocking. When that happens, production can continue to ramp up even if final demand is slowing.
Historically, inventory cycles have played a major role in overall GDP volatility. From 1947 through 1990, the average absolute quarterly change in U.S. economic output was about 1.2%—and the average absolute quarterly change in private inventories contributed about 0.6 percentage points to the overall change in GDP. Despite improvements in inventory management techniques (just-in-time manufacturing, etc) inventory liquidation nevertheless played a significant role in the 2001 downturn as well as in 2008-2009.
The good news is that this doesn’t seem to be the issue now. Part of the 2022Q1 GDP decline can be explained by the fact that price-adjusted inventories rose by a bit less in January-March than in October-December 2021 on a seasonally-adjusted basis. Inventories still rose by more, net of inflation, than in any other quarter besides 2021Q4. But what matters for GDP growth is the change in the change in the level of inventories, which flipped from positive to negative thanks to the normalization of demand from motor vehicle and parts wholesalers. That subtracted about 0.2 percentage points from the quarterly GDP growth rate.
The slowing pace of inventory accumulation, however, was not the main driver of the most recent downturn. (0.66% is much larger than 0.21%, after all.) Instead, the real problem was the plunge in net exports, which shaved off 0.8 percentage points from the quarterly growth rate.
That is extremely rare.
There have only been three quarters since the end of World War II when falling net exports counted more against U.S. GDP: 1947Q4, 1982Q3, and 2020Q3. Usually, the economy rolls over because consumers stop buying big-ticket items at the same time as businesses slash their capital budgets and run down their inventories. The pandemic was a partial exception to this general pattern, but even then, there was a clear link between the downturn in domestic spending and domestic production. Domestic production has dropped during periods of rising consumer spending and business investment only once before: 1982Q3.
The question is what—if anything—it means.