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US economy's 'contraction' is just a brief pause

A woman look at shoes on a display sale in New York, January 28, 2013.
A woman look at shoes on a display sale in New York, January 28, 2013.EMMANUEL DUNAND / AFP - Getty Images

The U.S. economy stopped dead in its tracks in the last three months of the year, according to the latest government data, as the halting recovery was slammed by Superstorm Sandy and fiscal cliff political gridlock.

But economists said the surprise 0.1 percent contraction in the fourth quarter's annual growth rate was likely a brief pause in an otherwise halting, four-year recovery from the 2007 recession.

 “This isn't the start of a new recession,” said Paul Ashworth chief U.S. economist at Capital Economics.

The Commerce Department's report on fourth quarter gross domestic product, the first of several that are typically revised as more data becomes available, followed a stronger-than-expected 3.1 bounce in growth during the preceding three months.Forecasters had been expecting a weak performance of about 1.1 percent growth in the final quarter of 2012 after Sandy shuttered millions of businesses and factories in early November. 

Besides the storm, the weakness appeared to be the result of other one-time factors, including the biggest defense spending cuts in 40 years and a slow build in company stockpiles. Those two factors alone slashed 2.6 percentage points from growth.

The big contraction in defense spending, which reversed an upswing in the third quarter, came as Congress remained deadlocked over compromise needed to avert across-the-board spending cuts known as the sequester. The  “fiscal cliff” compromise reached at the end of the year postponed those cuts until March 1. 

A top Defense Dept. official said last week that the Pentagon already is eliminating all 46,000 of its temporary civilian workers in anticipation of budget cuts. Deputy Defense Secretary Ashton Carter said that if Congress fails to head off mandatory budget cuts by March 1, some 800,000 Pentagon civilian employees will face furloughs and reduced paychecks by April, cutting spending by about $5 billion. 

The other big drag on third quarter growth, the draw-down in business inventories, followed a backup in merchandise in late summer after a slowdown in China and Europe left many U.S. manufacturers with unsold goods. As businesses sold off their backlogs by year-end, the sharp drop in inventories lopped off 1.3 percentage points in GDP growth.

Heavy equipment maker Caterpillar, Inc. said this week that it reduced its inventories by $2 billion in the fourth quarter as global sales declined from a year earlier. 

The draw-down means manufacturers are well-positioned for a pick-up in demand this year, according to Mark Zandi, chief economist at Moodys Analytics. 

“That augurs very well going into the first quarter,” he said. “You can feel things started to pick up again."

That pickup has been reflected in fresher data on the economy’s performance in December, including upbeat reports on home and car sales, business investment and manufacturing orders.  Those reports have raised hopes that the ongoing move to balance the federal budget with tax increases and spending cuts won’t dampen the emerging recovery.

Signs of strength
Ironically, the gloomy headline on Wednesday’s GDP report masked two additional signs of economic strength. 

Businesses and consumers were big spenders in the fourth quarter - despite worries that the ongoing budget gridlock had prompted both to sit on the sidelines until the standoff was resolved.  Consumer spending – which accounts for roughly 70 percent of GDP – was also up sharply, adding 1.5 percent to GDP. The recovering housing market added 3-tenths of a percent to growth.

Business investment in new equipment and software jumped 12.4 percent from the preceding three months, adding 9-tenths of a percent to the economy’s overall expansion rate. 

“The collapse in government spending and cautious inventory controls hide the simple fact that households are spending, businesses are investing and the housing market is expanding,” said Joel Naroff, chief economist at Naroff Economic Advisors.

The strength in consumer and business spending helps support the idea that the economy’s long-term trend of a fairly tepid 2 percent growth rate remains intact. The initial tally for all of 2012 showed the economy grew by 2.2 percent, a bit better than 2011's growth of 1.8 percent.

“The reality is that the economy is growing between 2 to 2.5 percent,” said Zandi. “That’s how fast it’s been growing since the recovery started two-and-a-half years ago.”

That growth pace is slower than typical recoveries in the last half century, which is why the unemployment remains stuck at painfully high levels. The economy has created roughly 150,000 jobs a month, on average, for the past two years, barely enough to keep up with population growth. As a result, the unemployment rate has been falling slowly and has remained stuck at 7.8 percent for the past two months.

Economists expect the government’s January jobs report Friday to show the unemployment rate remained at that level again this month. That tepid pace of growth and hiring is expected to continue into this year, due in part to the year-end budget deal that ended a two-year Social Security “tax holiday.” 

The increase will cost wage earners about two percent of their take-home pay (until they reach this year’s $113,700 income limit.) That means a household earning the median $50,000 a year will have about $1,000 less to spend. A household with two highly-paid workers will have up to $4,500 less.  

A key measure of consumer confidence plummeted this month after Americans noticed the reduction in their paychecks, the Conference Board reported Tuesday.

With growth historically weak and unemployment high, the Federal Reserve has promised to keep interest rates near zero, despite the potential long-term risk of inflation. Central bank Chairman Ben Bernanke has answered critics by saying that the Fed is ready to begin raising rates if price increases begin creeping back into the economy.

Though prices are rising in the housing and stock markets, there is little sign of inflation at the consumer or producer price level. Wage growth has also been flat since the recovery began. 

Still, the risk remains that the Fed’s “exit strategy," whenever it comes, will put another damper on the economy. 

“I’m afraid that house prices could get to depend on the extremely low mortgage rates which will turn around when the Fed stops its (low interest rate) policy,” said Harvard economist Martin Feldstein, who served as chief economic advisor to President Reagan. “At some point the Fed is going to have to start raising long term interest rates.”