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Why The Upward Revision in Third Quarter GDP Growth is Not Good News

The growth rate for GDP for the third quarter was revised upward from 2.5 percent to 2.6 percent, but a closer look at the numbers reveals it's actually not such good news. Dean Baker explains why:
Inventories and the Wonders of GDP Accounting, by Dean Baker: The news stories are coming out on the Commerce Department's release of revised data on 3rd quarter GDP and it seems that almost everyone has missed the story. The headlines of the articles are telling us that GDP growth was revised up slightly from 2.5 percent to 2.6 percent. While that may sound like at least somewhat positive news a more careful review of the data shows the opposite.
While the rate of GDP growth was revised up, the rate of final demand growth was revised down. Final demand, which is GDP excluding inventory accumulations, grew at just a 0.9 percent annual rate in the 3rd quarter, the same as its growth rate in the second quarter. The reason that GDP growth was revised upward was a more rapid reported growth in inventories.
The reported rate of inventory accumulation in the 3rd quarter was $121.4 billion (in 2005 dollars), the fastest pace ever. This added more than 1.6 percentage points to the rate of GDP growth in the quarter.
It is very unlikely that this pace of inventory growth will be sustained..., because the upward revision to GDP growth was based on more rapid accumulation of inventories it should not be viewed as a positive for the economy's growth prospects.
A graph may help. This is a graph of business inventories from the Cleveland Fed:

Business-inventories [via]

As is evident in the graph, inventories have been growing rapidly contributing to the growth in GDP, but if historical trends persist, that growth is about to come to an end. When it does, the growth rate of GDP will slow down unless some other component of GDP grows faster to compensate. However, it's hard to see how that will happen. The original stimulus package is coming to an end in the first two quarters of 2011, state and local governments continue to face large budget shortfalls, housing prices are still falling which will continue to place a drag on consumption, businesses are waiting for positive news about the economy -- business investment will follow the economy, not lead -- government is being pushed toward deficit reduction, Europe is struggling, and when these and other factors acting as headwinds against GDP growth are factored in, it's hard to be optimistic about growth in coming quarters. Note also that a 2.6% growth rate, while close to the historical average, only helps us to tread water. A 2.6 percent growth rate keeps us from losing more ground, but it is not fast enough to make up for past losses. Thus, even the 2.6 percent rate was less than we need.

Let's hope this pessimistic view of our prospects for growth in coming quarters is wrong, but it's hard to see how the 2.6 percent growth rate we had in the third quarter can continue unless some other sector of the economy grows at an unexpectedly high rate.