May 09, 2022
Many people were struck by the 1.4% drop in Gross Domestic Product or GDP in the first quarter of 2022, with some reports suggesting this was the beginning of a recession. That is not the real story of the first quarter GDP.
Instead, it looks like economic growth is continuing at a healthy rate. How can that be?
To understand this point, it is important to recognize how imports are counted in GDP, since the increase in imports subtracted 2.53 percentage points from GDP growth in the quarter.
Also, a drop in exports subtracted another 0.68 percentage points from GDP. This is likely also due to supply chain issues, as exporters couldn’t arrange for all the shipping containers they wanted.
Imagine that the sum of consumption spending, investment and government spending increased at 2.7% annual rate in the quarter. That’s exactly what they did so why is GDP down?
Now suppose that at American docks we offloaded $60 billion of goods from boats sitting offshore, increasing our imports by this amount in the first three months of 2022.
What Didn’t Change
On an annual basis, this additional $60 billion in imports would be $240 billion, or roughly 1.0% of GDP. This would reduce GDP by this amount, even though our purchases for consumption, investment and the government had not changed.
OK, that story is not exactly right. The goods that we offloaded from the ships are now sitting in warehouses at the ports or are on their way to the retail outlets where they will eventually be sold.
This increase in inventories would raise GDP by an amount equal to the growth in imports, offsetting the drag that imports otherwise would have been on growth. However, inventories were actually a drag on growth in the quarter, subtracting 0.84 percentage points from GDP.
These two facts can be reconciled by looking at the actual amount that inventories increased in the first quarter. The report showed that inventories increased at a $158.7 billion annual rate.
Non-farm inventories rose at an even more rapid $185.3 billion annual rate. Farm inventories shrank at a $35.8 billion rate, continuing a pattern that has been going on for 16 years, but that is another story.
Inventories Growing Fast
This is an extremely fast pace of inventory accumulation. By comparison, in the years of 2016-2018, three normal years of economic growth, inventory accumulation averaged $45 billion.
The reason inventories were a negative factor in growth in the first quarter, in spite of this extraordinary rate of accumulation, is that inventories grew at an even more rapid $193.2 billion annual rate in the fourth quarter of 2021. That rise added 5.32 percentage points to the fourth quarter’s growth.
So how do we think about first quarter growth? It probably makes the most sense to focus on the measure of final demand to domestic purchasers. That figure rose at a very healthy 2.6% annual rate. This is measuring the growth in consumption, fixed investment and government expenditures.
If we want the fullest picture, we can combine the fourth quarter’s 6.9% growth rate with the first quarter’s 1.4% decline to get a 2.8% average growth rate for the last two quarters.
In addition to recognizing that the economy is still growing at very healthy pace, inventories have been largely rebuilt despite continuing supply-chain problems.
Real non-farm inventories at the end of the first quarter were just 0.1% below their pre-pandemic levels. This is a very positive sign. It should mean that the prices of many items which rose sharply in the last year will be leveling off and quite likely coming down.
In short, rather than being a bad report with a drop in GDP, this report is overwhelming good news. It shows that the main components of final demand, consumption, investment and government expenditures, are still growing at a healthy pace.
And, it shows that inventories have been largely rebuilt, meaning that supply-chain problems are being alleviated. Inflation is of course a problem, but this rise in inventories is exactly what we want to see if inflation is to be slowed.