Recently, business headlines around the world announced that the “U.S. Recovery Stumbles Yet Again.” These headlines trumpeted news that the U.S. economy shrank by 0.7% during the first quarter of 2015. This 0.7% figure is a large exaggeration of what actually happened to the economy last winter.
The size of the U.S. economy is measured by Gross Domestic Product, or GDP. GDP tracks how much was produced within a country’s borders in both goods and services, regardless of the nationality of the workers. During 2015 the U.S.’s GDP, currently the largest in the world, will be about $17.7 trillion dollars. Multiplying the 0.7% figure that was widely reported in the news by $17.7 trillion made it appear that the U.S. economy lost about $124 billion of output this past winter due to the terrible weather.
However, the U.S. economy did not lose this much output. The actual loss was much smaller and became magnified because of how GDP figures are reported. Each quarter a federal government agency called the Bureau of Economic Analysis (BEA) collects and then releases successively better estimates of the U.S. economy’s size. Every official BEA press release shows the U.S. economy in annual terms. Annual terms means both the quarterly change and quarterly level of GDP are multiplied roughly by four before being shown publicly. The figures are roughly four because the BEA takes into account compounding.
In simple terms during this past winter the U.S. economy did not shrink either by 0.7% or by $124 billion. Instead, after removing the annual adjustment the economy during the quarter shrank by roughly one-fourth of 0.7%, or just 0.175%, which is a $31 billion loss. If the economy continues to shrink during all four quarters at the same rate, the economy will be 0.7% smaller than the year earlier but few economists expect the winter slump to last all year. Moreover, some economists believe that the first quarter numbers are not trustworthy because the seasonal adjustment factors are faulty.
The U.S. has a very complex economy and the government’s goal is to provide GDP information as fast and as accurately as possible. So why does the BEA produce all figures in annual terms? The BEA’s FAQ directly answers this question and states “For ease of comparison, BEA publishes percent changes in most quarterly estimates at annual rates.” While the motivation is laudatory, few business managers, traders or even economists know about the exaggeration underlying the quarterly GDP figures.
The Economist back in 2011 noted that while Europe reported GDP figures in quarterly terms, the U.S. method of annualizing the numbers “can show the American economy in an overly flattering light.” While the spirit of the message stays true the negative value means that annualizing the data casts the American economy in an overly unflattering light whenever the economy shrinks, like it did this past winter.
UPDATE: On June 24 the BEA revised the 1st quarter’s GDP growth from -0.7% to -0.2% (see article here). Dividing by four means the quarters change was about 0.05%. Since there is some statistical uncertainty about the true GDP number, there is a high likelihood the economy neither contracted nor expanded, but simply produced the same amount during Q1 as before.