In my previous post, I discussed how the 2008Q2 advance GDP estimate would be revised, and the possibility that the final figure (after annual revisions) could enter in below zero. One reason that might occur is because the GDP deflator could be revised upward. Suspicion that this might occur is heightened by the seemingly implausible 1.1% SAAR inflation rate recorded for the GDP deflator (see the comments to this post, as well as Felix Salmon, and ). One question I want to address is whether this figure is actually so implausible.
I think the answer is no. And the reason is the distinction between the GDP deflator, which measures the price level for goods and services produced, and the gross domestic purchases deflator, which measures prices of goods and services purchased. Specifically, the two price indices pertain to these two concepts, respectively:
GDP = C + I + G + EX – IM
Gross domestic purchases = C + I + G
Where C is consumption, I is investment, G is government spending on goods and services, EX is exports and IM is imports.
To illustrate the difference between the two concepts concretely, consider the following. From the perspective of the household, we as individuals are certainly more familiar with the goods that we’ve spent funds on, as opposed to those consumer goods produced by the US economy, some of which are exported. The prices of those two bundles can obviously differ.
It turns out that over long spans of time, the price deflator for production and expenditures match trends (are cointegrated, in log-levels), but over short periods, they can diverge. And indeed, inflation rates have diverged substantially over the past few quarters.
Figure 1: Four quarter inflation rate for GDP deflator (blue) and gross domestic purchases (red), calculated as 4 quarter log difference. NBER-defined recession dates shaded gray. Source: BEA GDP release of 31 July 2008, and author’s calclulations.
Figure 1 highlights how the inflation rate for what we buy has accelerated over rates for what we make. Is this surprising? No, I think it’s a natural implication of the United States running a massive current account deficit that the rest of the world no longer wishes to finance on the (favorable) terms it previously received. Interest rates and the rate at which we trade US goods for foreign goods (both knzn and Stefan Karlsson note the importance of this terms of trade effect) must adjust. As many observers indicated several years ago, if you borrow and consume in excess of production, sometime in the future, you may have to pay back by producing in excess of consumption. That process will be facilitated by a change in the terms at which home (US) goods exchange for foreign goods (see this Council on Foreign Relations special report and references therein). And this is what we are seeing occur now. The credit card bill has come due.
Nor is this a surprise to those who have been following the evolution of tradables prices. Figure 2 shows how goods import prices have moved with the dollar’s decline. Total goods import prices have risen more than the dollar decline since oil prices have jumped up. But even prices of imports ex-oil have risen substantially.
Figure 2: Log level of nominal dollar exchange rate against a broad basket of currencies (blue), goods import deflator (red) and goods import deflator ex oil (green), normalized to 2002Q1. NBER-defined recession dates shaded gray. Source: BEA GDP release of 31 July 2008, Federal Reserve Board via St. Louis Fed FRED II, and author’s calclulations.
Another way at looking at the divergence between the GDP deflator and the gross domestic purchases deflator is to note the differential rate of inflation for the tradables (goods imports, imports ex. oil, exports) and the GDP deflator. That is shown in Figure 3.
Figure 3: Annualized quarter-on-quarter inflation rate for goods imports (blue), goods imports ex oil (red), exports (green), and GDP deflator (black), calculated as log first differences. Source: BEA GDP release of 31 July 2008, and author’s calclulations.
Thus, it seems to me that we should anticipate that over time, we should continue to see a disjuncture between the GDP deflator, and what we think should be the price level.
This is not to deny the possibility that the GDP deflator might be revised upward. That could happen. But my view is that a lot of the puzzlement abounding can be resolved by recognizing the difference by the GDP deflator and the gross domestic purchases deflator.