Steep Drop in GDP May Also be First Sign of Economic Recovery

By Don Miller
Associate Editor
Money Morning

U.S. gross domestic product (GDP) plunged at a surprisingly sharp 6.1% annual rate in the first quarter, marking its worst performance in 50 years, the Commerce Department reported today (Wednesday). 

The drop was much steeper than the 4.9% annual rate expected by economists and follows a 6.3% tumble in the fourth quarter of 2008. But a look inside the numbers shows that things may not be as bad as they look.

Plummeting exports and massive inventory reductions accounted for most of the fall. And increases in government and consumer spending have some analysts convinced the future looks much brighter.

"This is one of those good-bad numbers," Joel Naroff, president of Naroff Economic Advisors Inc. in Holland, Pa, wrote in a note to investors. "Businesses are running about as lean as they possibly can be. It sets up the reality that any sort of increase in demand will cause firms to have to increase production."

Companies slashed inventory stockpiles at a $103.7 billion annual pace from January through March, the largest drop since records began in 1947. That knocked 2.79% off of the overall GDP figure.  Without that reduction the economy would have contracted at a 3.4% pace, according to Reuters.

The dramatic plunge in inventories is good news because it shows manufacturers and retailers are emptying their warehouses of unsold merchandise, reducing stockpiles to manageable levels, and setting the stage for increased production as consumer demand picks up.

"To the degree that that's a sign that firms are bringing down some of their inventories ... that combined with consumers coming back to life could mean we need to start producing things again," Christina Romer, the head of the White House Council of Economic Advisers, told Reuters. "It could put us in a position for perhaps a less dreary number going forward."

Consumer spending, which accounts for about 70% of U.S. economic activity, is finally showing signs of life after collapsing in the second half of 2008.  Americans spent a whopping 9.4% more on durable goods in the quarter, leading to an overall 2.2% rise in consumer spending, the first advance after four straight quarters of declines.

"This is the combination you want for a turn in the economy -- better sales and an inventory correction," John Silvia, chief economist at Wachovia Corp. (WB) in Charlotte, North Carolina, told Bloomberg News.

Exports were a main factor in the overall decline, collapsing by 30% - the biggest decline since 1969 - after dropping 23.6% in the fourth quarter. The decline in exports knocked a record 4.06 percentage points off GDP.

Business investment, including equipment, software and construction projects, tumbled a record 38% in the first quarter, reflecting the focus on reducing inventories.  Residential construction also fell 38%, the biggest decline since the second quarter of 1980.

If the economy shrinks again in the second quarter as projected by economists surveyed this month by Bloomberg, the recession that began in December 2007 would be the longest since the Great Depression.

But recent data have shown signs of stability in home sales, home construction and consumer confidence, suggesting the world's largest economy may finally be turning a corner.

Some improvements can be expected from new government spending programs. Government spending was slashed at a 3.9% pace in the quarter, the most since 1995. The drop reflected cutbacks in defense spending and the biggest decline outlays by state and local government since 1981.

With Congress passing President Obama's $787 billion rescue package of spending and tax cuts, economists expect government spending to skyrocket throughout the rest of 2009 and into 2010. Part of the stimulus package is designed to bolster state and local and government spending.

The stimulus package has been further supplemented by other government spending programs designed to bring the recession to an end, including the Federal Reserve's pledge to double mortgage-debt purchases to $1.45 trillion and buy as much as $300 billion in long-term Treasuries.

The Commerce Department said the government stimulus package, approved in February, had little impact on first-quarter GDP.

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