Real GDP Up 5.7 Percent: Good News and Bad

First, the good news. The preliminary estimate is that real GDP increased at a 5.7 percent annual rate in the fourth quarter of 2009, rising from $12,973 billion to $13,155 billion. This measures the production of consumer goods and services, capital goods, and government goods and services.

The long run trend growth rate of real GDP is a little more than 3 percent per year, so this is better than average growth. Further, according to the Congressional Budget Office, the productive capacity of the economy only grew at a 1.77 percent annual rate in the fourth quarter of 2009.

Is it a problem that the production of goods and services expanded faster than capacity? On the contrary, real GDP in the fourth quarter of 2009 was nearly 2 percent below the peak reached in the second quarter of 2008. Worse, it is 9.57 percent below its trend growth path and 6.17 percent below the CBO's estimate of the productive capacity of the economy. Real GDP, the real volume of goods and services produced, can only catch up if it grows faster than productive capacity.

Real GDP, its trend, and the CBO estimate of potential output is shown below for the entire period of both the Great Moderation and the Great Recession. The sharp drop in real GDP is apparent.

The current shortfall of real GDP relative to both its trend and the CBO estimate of potential output shows up clearly when looking at the Great Recession.

If real GDP continues to grow at an annual rate of 5.7 percent and productive capacity continues to grow at an annual rate of 1.77 percent, real GDP would return to productive capacity in about 18 months. (CBO projects less than 2 percent growth for productive capacity until 2012.)

Unfortunately, it is doubtful that real GDP will continue to grow at such a rapid rate. The real volume of final sales of consumer goods, capital goods, and government goods only increased at a 2.2 percent annual rate. The other 3.5 percent was an increase in inventories--goods produced but not sold.

The best possibility would be that firms expect rapid increases in sales in the future and expanded production in preparation. If they were correct, then strong production should continue. The worst possibility would be that firms expanded production in the fourth quarter expecting strong sales, but they didn't materialize. The firms have accumulated large stocks of unsold goods and they will reduce production in the future until they sell off these excess inventories.

The third possibility is that firms had sold off inventories in the past, and now are rebuilding those inventories to more normal levels. If that is correct, then next quarter, production should come closer to matching final sales (increasing 2.2 percent) because inventories will have been replenished. Most business economists are talking about this third alternative.

So, the bad news is that last quarter's strong growth of real GDP is unlikely to be repeated, and real GDP remains far below its trend growth path and well below the CBO estimate of the productive capacity of the economy.

Perhaps something new should be tried? Maybe a target for a growth path for nominal expenditures would help return the production of goods and services to capacity?