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The Trader's Guide to Key Economic Indicators
By Richard Yamarone
Bloomberg PressCopyright © 2004 Richard Yamarone
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Chapter OneGross Domestic Product
Economics has received a bad rap. In the mid-nineteenth century, the great Scottish historian Thomas Carlyle dubbed this discipline "the dismal science," and jokes about economists being more boring than accountants abound on the Street. But truth be told, there is nothing more exciting than watching the newswire on a trading floor of a money-center bank minutes ahead of the release of a major market-moving economic report. One of the top excitement generators is the report on gross domestic product (GDP)-an indicator that is a combination of economics and accounting.
Economists, policymakers, and politicians revere GDP above all other economic statistics because it is the broadest, most comprehensive barometer available of a country's overall economic condition. GDP is the sum of the market values of all final goods and services produced in a country (that is, domestically) during a specific period using that country's resources, regardless of the ownership of the resources. For example, all the automobiles made in the United States are included in the GDP-even those manufactured in U.S. plants owned by Germany's DaimlerChrysler and Japan's Lexus. In contrast, gross national product (GNP) is the sum of the marketvalues of all final goods and services produced by a country's permanent residents and firms regardless of their location-that is, whether the production occurs domestically or abroad-during a given period. Baked goods produced in Canada by U.S. conglomerate Sarah Lee, for example, are included in the United States' GNP, but not its GDP.
GDP is a more relevant measure of U.S. economic conditions than GNP, because the resources that are utilized in the production process are predominantly domestic. There are strong parallels between the GDP data and other U.S. economic indicators, such as industrial production and the Conference Board's Index of Coincidental Indicators, which will be explored in later chapters.
The GDP is calculated and reported on a quarterly basis as part of the National Income and Product Accounts. The NIPAs, which were developed and are maintained today by the Commerce Department's Bureau of Economic Analysis (BEA), are the most comprehensive set of data available regarding U.S. national output, production, and the distribution of income. Each GDP report contains data on the following:
* personal income and consumption expenditures
* corporate profits
* national income
These data tell the story of how the economy performed-whether it expanded or contracted-during a specific period, usually the preceding quarter. By looking at changes in the GDP's components and subcomponents and comparing these with changes that have occurred in the past, economists can draw inferences about the direction the economy might take in the future.
Of all the tasks market economists perform, generating a forecast for overall economic performance as measured by the GDP data is the one to which they dedicate the most time. In fact, the latest report on GDP is within arm's reach of most Wall Street economists. Because several departments in a trading institution rely on the economist's forecasts, this indicator has emerged as the foundation for all research and trading activity and usually sets the tone of all of Wall Street's financial prognostications.
Evolution of an Indicator
Measuring a nation's output and performance is known formally as national income accounting. This process was largely pioneered by Simon Kuznets, an economist hired by the U.S. Department of Commerce in the 1930s-with additional funding from the National Bureau of Economic Research-to create an accurate representation of how much the U.S. economy was producing. Up to that time, there was no government agency calculating this most critical of economic statistics.
The initial national income estimates produced by Kuznets in 1934 were representations of income produced, measures of the national economy's net product, and the national income "paid out," or the total compensation for the work performed in the production of net product. At that time, no in-depth breakdown of components yet existed. In fact, Kuznets didn't even have a detailed representation of national consumption expenditures. This was the first step of several in the creation of a formal method of national income accounting, and yet was still a far cry from today's highly detailed representation of the macroeconomy.
The result was the National Income and Product Accounts. In addition to this immense task, Kuznets reconstructed the national income accounts of the United States back to 1869. (He was awarded a Nobel Prize in Economics in 1971 in part for this accomplishment.) Kuznets's first research report, presented to Congress in 1937, covered national income and output from 1929 through 1935.
In 1947, the first formal presentation of the national income accounts appeared as a supplement to the July issue of the Survey of Current Business. This supplement contained annual data from 1929 to 1946 disseminated in thirty-seven tables. These data were separated into six accounts:
1. national income and product account
2. income and product account for the business sector 3. government receipt/expenditure account 4. foreign account
5. personal income/expenditure account
6. gross savings and investment account
Before the creation of the NIPAs, households, investors, government policymakers, corporations, and economists had little or no information about the complete macroeconomic picture. There were indices regarding production of raw materials and commodities. There were statistics on prices and government spending. But a comprehensive representation of total economic activity wasn't available. In fact, the term macroeconomy didn't appear in print until 1939. Policymaking without knowing the past performance of the economy, how it operated under different conditions and scenarios, or which sectors were weak and which were strong was a daunting task. This may have been the reason for many of the economic-policy failures of the early twentieth century.
Many economists have laid the blame for the Great Depression of the 1930s on the Federal Reserve's failure to respond to the ebullient activity during the Roaring Twenties (sound familiar?). The Fed may bear much of the responsibility; but very few, if any, have defended the Federal Reserve's failures on the grounds of insufficient information. The Great Depression forced the government to develop some sort of national accounting method. World War II furthered the government's need to understand the nation's capacity, the composition of its output, and the general economic state of affairs. How could the government possibly plan for war without an accurate appreciation of its resources? The NIPAs permit policy-makers to formulate reasonable objectives such as higher economic growth rates or lower inflation rates as well as to formulate policies to attain these objectives and steer the economy around any road-blocks that might impede the attainment of these goals.
Digging for the Data
Tracking the developments in an economy as large and dynamic as that of the United States is not easy. But through constant revision and upgrading, a relatively small group of dedicated economists at the BEA accomplishes this huge task every quarter. Each quarterly report of economic activity goes through three versions, all available on the BEA website, bea.gov. The first, the advance report, comes one month after the end of the quarter covered, hitting the newswires at 8:30 a.m. ET. So, the GDP report pertaining to the first three months of the year is released sometime during the last week of April, the second quarter's advance report during the last week of July, the third quarter's in October, and the fourth quarter's during the last week of January of the following year. Because not all the data are available during this initial release, the BEA must estimate some series, particularly those involving inventories and foreign trade.
As new data become available, the BEA makes the necessary refinements, deriving a more accurate estimate for GDP. The second release, called the preliminary report, comes two months after the quarter covered, one month after the advance report, and reflects the refinements made to date. The last revision to the data is contained in the final report, which is released three months after the relevant quarter and a month after the preliminary report. The release dates for 2003 are shown in FIGURE 1-1.
Annual revisions are calculated during July of every year, based on data that become available to the BEA only on an annual basis, such as state and local government consumption expenditures. The BEA estimates these data on a quarterly basis via a judgmental trend based on annual surveys of state and local governments. Judgmental trends are quarterly interpolations of source data that are only available on an annual basis. Because the surveys are available on an annual basis, estimates can only be made during the annual revision.
As source data for the components of the accounts are continuously updated and revised, the components of the NIPAs must be updated to reflect these revisions. That's the primary function of the annual revision. Each of the three years (twelve quarters) worth of data is subject to revision during this annual updating. Every five years the BEA issues a so-called benchmark revision of all of the data in the NIPAs. This typically has resulted in considerable changes to the five years of quarterly figures.
Benchmark revisions are different from annual revisions in that they generally contain major overhauls to the structure of the report, usually definitional, reclassifications, and new presentations of data. New tables need to be created to account for products that are developed. As the economy evolves, new goods and services come to market and therefore need to be accounted for. Obviously, there were times when CDs, microwave ovens, MP3 players, and DVDs didn't exist. Because the U.S. economy develops and produces these goods, there needs to be a place for this production to be recorded. All of the data-quarterly and annual-are revised during benchmark revisions.
As noted previously, the GDP is the sum of the market values of all final goods and services produced by the resources (labor and property) of a country residing in that country. This definition contains two particularly important terms: final and produced. When economists refer to final goods, they mean those goods produced for their final intended use, that is, as end products, not as component or intermediate parts in another stage of manufacture. As an example, consider that each year, Goodyear Tire & Rubber produces some hundred million tires. Most are produced for use on new vehicles. But there are still quite a number created for distribution in retail and wholesale stores as replacements and spares. Those tires produced and delivered to automakers intended for use on new automobiles are not counted as production because we do not calculate the value of automobiles in the national accounts by summing the value of its components. In other words, we don't add the cost of the radio, the seats, the heating elements, the spark plugs, and so on. We only count the value of the final product, the automobile.
Obviously, the economists at the BEA would make a serious miscalculation if they counted all the tires sold by the manufacturer to Wal-Mart and Sears, as well as those sold by the automakers as part of their automobiles. The same holds true for the production of wool. BEA economists only count the wool purchased for final use. Because countless final uses exist for wool-sweaters, hats, blankets, and so on-the BEA would make the same double-counting error by adding the production of raw wool as well as the wool used in sweaters, blankets, and the like.
Let's consider the other important term, produced. Resales are not included in the accounts. Rightfully so, the BEA has determined that because the pace of reselling is not indicative of the current pace of production, it shouldn't be included in the output figures.
Another segment of the economy that the BEA excludes from the GDP release is the activity that goes on "off the books." This seems an obvious exclusion, but it's a big one. Believe it or not, some of the most conservative studies have set the size of the U.S. underground economy at around 10 percent of the official U.S. GDP, or what was roughly $1 trillion in the first quarter of 2003. The BEA doesn't count or make any adjustments for non-state-sanctioned gambling, prostitution, trade in illegal drugs, fraud, the production and sale of counterfeit merchandise, and the like because, officially, they don't exist-wink, wink, nudge, nudge. These activities aren't reported, so how can they be measured? Clandestine activity like this can understandably alter the estimate of several economic indicators, but none more than the GDP.
GDP Versus GNP
The NIPAs contain figures for both gross domestic product and gross national product. Before 1991, GNP was the benchmark for all economic activity in commentaries, reports, articles, and texts. The GDP became the official barometer when the BEA decided that the measure was a better fit with the United Nations System of National Accounts used by other nations, and so made international comparisons of economic growth easier.
GDP differs from GNP in what economists call "net factor income from foreign sources": the difference between the value of receipts from foreign sources and the payments made to foreign sources. The table in FIGURE 1-2, using data from the final GDP report of the fourth quarter of 2002, illustrates how the BEA quantifies this relationship in its GDP report.
The difference between the value of GDP and GNP is typically minuscule, usually less than 0.5 percent. In Figure 1-2, for example, GDP is approximately $10.588 trillion and GNP $10.579 trillion, a difference of under $10 billion, or 0.09 percent.
Calculating GDP: The Aggregate Expenditure Approach Every transaction in an economy involves two parties, a buyer and a seller. To calculate total economic activity, economists can focus either on the buyers' actions, adding together all the expenditures on goods and services, or on the sellers' actions, tallying the total income received by those employed in the production process. These two approaches correspond to the two methods of calculating the GDP: the aggregate expenditure method, which is the more popular and the one used on most Wall Street trading floors, and the income approach.
Excerpted from The Trader's Guide to Key Economic Indicators by Richard Yamarone Copyright © 2004 by Richard Yamarone. Excerpted by permission.
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