Outside the Beltway

The Economy Actually Shrank In The First Quarter Of 2014

In no small part because of a brutal winter, the economy shrank in the first three months of the year.

Doug Mataconis · Thursday, May 29, 2014 · 15 comments

When the first estimate of the health of the nation’s economy was released last month, the news was quite disappointing. While the final quarter of 2013 had shown the economy in surprisingly strong shape, the Commerce Department reported that economic growth in the first three months of 2014 was an anemic 0.1 percent. As I noted at the time, that number would be subject to two revisions in May and June, and if the May revision is any indication the first quarter was even worse than initially thought:

It was a quarter to forget.

Even as the winter of 2014 fades in the rearview mirror and growth shows signs of picking up, it is becoming clearer just how much the economy slowed in the first quarter.

The Commerce Department said Thursday the economy shrank at an annual rate of 1 percent in the first quarter, revising its initial estimate last month that showed a very slight gain for the period. It is the first quarter in three years in which the nation’s output of goods and services has contracted.

The bulk of the downward revision in gross domestic product was driven by reduced additions to inventories by businesses as well as a slightly weaker trade balance than first thought. The smaller stockpiles alone subtracted 1.6 percent from the growth rate.

“Ouch,” said Ian Shepherdson, chief economist at Pantheon Macroeconomics, in a note to clients immediately after the release of the report. “The bad news is that the headline G.D.P. number is worse than consensus, but the good(ish) news is that almost all the hit is in the inventory component.”

To be sure, lower additions to inventories by businesses in the first quarter suggest that factor won’t weigh on growth as much in the second quarter, when other economic indicators are expected to pick up. Most economists expect the growth rate to rise to 3 to 4 percent in the second quarter.

In a separate economic report from the Labor Department on Thursday, initial claims for unemployment last week dropped more sharply than expected. That suggests the labor market continues to improve, Mr. Shepherdson said, a critical factor if the economy is to achieve sustained momentum in the future.

“This report is more important than the G.D.P. numbers, in our view, because it strongly supports the idea that labor market conditions are improving markedly, despite weak headline growth during the winter,” Mr. Shepherdson added.

A final revision of the first quarter’s performance will be released June 25.

“I don’t believe the economy is in any danger,” said Gus Faucher, senior economist at PNC Financial Services, in an interview before the release of the data. “We had a hit in terms of weather and we will see a bounce-back in activity in the second quarter.”

Still, the on-again, off-again pattern of economic expansion in the current recovery explains why so many Americans remain skeptical that things really are getting better, despite strong corporate profits and a booming stock market.

Earlier this week, the Standard & Poor’s 500-stock index hit a fresh high, and the index is up over 3 percent so far this year. In 2013, the S.&P. index rose nearly 30 percent.

Despite the likelihood of a pickup this quarter, economists have been reassessing the prospects for growth over the next year or two, said Michael Hanson, senior United States economist at Bank of America Merrill Lynch.

“Many market participants are pricing in lower growth than they expected six months ago,” said Mr. Hanson, adding that these concerns about the potential of the economy to sustain faster growth over time may help explain why investors have piled into Treasury bonds recently, including on Wednesday, driving yields sharply lower.

At 2.45 percent Wednesday, the yield on the benchmark 10-year Treasury bond was close to lows last seen a year ago, when the Federal Reserve started to signal it would begin easing its efforts to stimulate the economy.

While the weak number we saw last month was bad news, there’s something significant from the perspective of market psychology about the fact that the economy may have actually shrunk at the beginning of the year. If the number holds up in next month’s revision, it would be the first quarter of negative growth since the Great Recession ended in 2009 and if, by some chance, we ended up with negative growth in the second quarter of the year, we would officially be in a recession. The good news, I suppose, is that it seems unlikely that the second quarter will be quite as bad as  the first quarter was.  For one thing, underlying numbers for April and May that have been released to date don’t show the indications of a shrinking economy that you’d expect to see. For another, the role that the unusually cold and snowy winter played in economic activity during the winter should not be discounted. That weather impacted travel, transportation, and consumer activity over wide swaths of the United States for an extended period of time so, as Reuters notes, it’s not entirely surprising that we’re seeing an economic impact:

The slump was entirely expected, and economists aren’t too worried. They forecast a bounce back in the spring.

Take for example Joseph Lavorgna, chief U.S. economist at Deutsche Bank. He predicts the economy will rev up, growing at more than a 4% pace in April through June. In a note to clients this week, he cautioned investors not to worry if the first quarter numbers were lousy.

The January through March period tends to be the slowest for growth, he noted, and this year, colder than usual weather stunted retail sales, international trade and the housing market.

Businesses also cut back on investments in new equipment and buildings, and state and local governments reduced their spending.

The downward GDP revision came primarily from a decline in business inventories, meaning companies weren’t quick to re-stock their shelves or stockpile goods to prepare for future sales. Stuart Hoffman, chief economist for PNC Bank, points to the auto sector as an example.

When snow and ice kept customers away from auto lots in the winter, automakers slowed their production lines.

“There were too many unsold cars on the lot, so they cut production, and that holds the economy back,” Hoffman said. “Now those cars are selling again and production will come back.”

Indeed, data released in the last few months now shows auto sales are booming, both the manufacturing and services sectors are improving, and job growth is solid.

“The first quarter was disappointing, but rather than view that as an omen of a recession or the first of a down leg in the economy, I see the seeds of a big bounce back in spring,” Hoffman said.

CNBC’s write-up of the report agrees with that analysis, but their own Rick Santelli is less optimistic

And Vox is downright pessimistic:

The latest estimate is also more dismal than experts had guessed — their consensus estimates had been at -0.5 percent, according to Bloomberg. Many economists expected a bad first quarter not because of fundamental economic weakness, but because of an unusually harsh winter.

The Commerce Department revises its estimates as it receives more complete data. And new data the government has received in the last month has shown that business investment in inventories — goods that have not yet been sold to customers — fell by even more in the first quarter than the government had previously thought.

Even more troubling, another measure of economic growth — gross domestic income — fell by 2.3 percent last quarter. GDI and GDP should theoretically be equal to each other and broadly track together, but they rarely match up perfectly in these estimates of economic output. However, that GDI fell even more than GDP last quarter is yet more evidence that the economy really took a beating over the cold, snowy winter, and may even signal that the economy in fact shrank even more than 1.0 percent.

Even if the economy does “bounce back” in the second quarter, this dismal report doesn’t bode well for the future. At the very least, it suggests that the previous optimistic of economic growth in 2014 will not pan out and that the projections of some analysts of 4% or better growth, which is better than we’ve seen for the entire recovery, are going to be way off the mark. More likely than not, we’re going to see more of the same ‘okay but not great’ economic growth that has characterized the post-recession economy. While that’s better than a recession obviously, it’s hardly a sign of health. Indeed, if snow and cold weather were enough to through the economy into negative growth for even a short period then that alone would seem to tell us that the economy is far more vulnerable to shocks than we might have otherwise thought. Will the same thing happen if we end up with a more active than expected hurricane season this summer? And what about next winter? As much as we can expect bad weather to have negative economic consequences, when it starts throwing the economy into negative territory, it’s arguably time to start worrying about the fundamentals of that economy and just how strong they actually are.