GDP: Arithmetic and Forecasting

Estimates of 4Q19 GDP growth fell sharply in mid-November, but rebounded in the last week. For example, the Atlanta Fed’s GDP Now model fell to 0.3% annual rate following the October reports on retail sales and industrial production. Currently, the Atlanta Fed’s estimate stands at 1.7%, reflecting better-than-expected figures on durable goods shipments and a drop in imports. We’re still missing data for most of the fourth quarter, and the picture will change as more information becomes available. However, the underlying story may not change much.

There are two broad approaches to forecasting current quarter GDP. Some economists will estimate a number and stick with it. Most will adjust their forecasts as new data arrive. This may seem fickle to the casual observer. Estimates will change week to week and even day to day (as with the Atlanta Fed’s model). Most economists forecast the GDP components and add them up. The difference is how the components are estimated.

Consumer spending accounts for 68% of GDP. About 69% of that is services, led by housing and healthcare. Durable goods make up about 10.6% of consumer spending, but account for much of the variability in an economic downturn (durables include motor vehicles, home furnishings, and appliances – “big-ticket” purchases). Note that consumer spending growth tends to be uneven from quarter to quarter. This holiday shopping season is expected to be strong, especially in comparison to last year’s disappointing results. However, the seasonally adjusted gain from 3Q19 is unlikely to be as stellar.

Business fixed investment is generally 13-14% of GDP, and includes both old style (machinery and equipment) and new style (computers, software) capital spending. It is made up of structures (21%), equipment (43%), and intellectual property products (36%). Intellectual property products consists of software (41%), research and development (50%), and “entertainment, literary, and artistic originals” (9%). Business fixed investment accounts for most of the swing in recessions and recoveries.

Residential fixed investment, mostly homebuilding, was 3.7% of GDP in 3Q19. As a percentage of GDP it rose to about 6% during the housing boom and fell to around 2% during the bust. Traditionally, homebuilding has been the canary in the coal mine, weakening early in a recession and rebounding sharply in a recovery. However, the 2007-09 financial crisis changed all that. Residential fixed investment improved in 3Q19, following a six-quarter decline.

These three components, consumer spending, business fixed investment, and residential investment make up Private Domestic Final Purchases (PDFP), the preferred measure of underlying private-sector domestic demand. Equivalently, PDFP is GDP less government, net exports, and the change in inventories. PDFP is less volatile than GDP.

Government consumption and investment includes both federal (38%) and state and local government (62%). Defense accounted for 59% of the federal government component of GDP in 3Q19. Note that transfer payments, such as Social Security, do not appear in GDP.