Gross Domestic Product - US economy, economic indicators, economics, interest rates, inflation

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• published: 13 Apr 2016
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The quarterly GDP report released by the Bureau of Economic Analysis BEA, a department in the US Department of Commerce. Before we dive into this report to understand the composition of consumption, government spending, investments, and net exports, we need to understand the historical context of GDP in the country of interest. It would benefit us to research past GDP cycles and what the levels of stocks, bonds and foreign exchange markets were during periods of recession, boom or steady growth. It would also benefit us to look at inflation and interest rate levels historically to get a better feel of their relationship with growth rates. A study of the history of growth rates in relation to other macroeconomic factors such as inflation and interest rates,...plus the reaction of market participants and central banks at different levels of growth will improve our ability to predict whether the central bank will raise or lower interest rates on the release of certain indicators. By studying the history of growth of a particular economy we can determine whether the central bank will take preemptive measures when the economy is sliding into recession, or overheating. Now we look the historic growth rates in the US economy and why central banks and policy makers strive to contain growth within a sustainable level. The growth rate an economy will experience can fall under the 3 phases – high growth, sustainable growth and recession. It is important to understand the historic context of growth in that particular economy in order to classify growth under the three categories. A high growth of say 6-7% in a highly developed economy such as the US might not be sustainable unless the economy is just moving out of recession but can be the average growth rate in a emerging economy such as India or China. The general consensus is that real growth between 2.5%-3.5% in the US is sustainable without inciting inflationary concerns. In countries such as the US, during high growth periods when the economy is expanding at 6-7%, the demand for goods and services is rapid and puts an upward pressure on prices. Price increases overtake wage increases dampening consumer spending. Consumers start spending on borrowed money thereby increasing debt expansion. High inflation and increased debt spending causes the Federal Reserve bank to react by increasing interest rates to cool the economy. An increase in interest rates increases borrowing costs for firms thereby reducing debt expansion and business investments bringing the economy to slowdown. The reverse happens during a recession. A recession is defined as 2 consecutive quarters when the real GDP is negative. In this scenario the central bank reduces interest rates to boost spending. Lower costs of borrowing for consumers and corporates induces spending and investments. Thus it is usually seen that when the real GDP moves above or below a sustainable growth rate the central bank uses its monetary tools to bring it back to a sustainable level. Before we start analyzing the components of GDP lets first clarify certain basic concepts such as growth rates and the difference between real and nominal GDP. Lets begin with growth rates. As we mentioned earlier the absolute GDP number computed by aggregating C+G+I+EX-IM, has no significant meaning for anyone. It doesnt tell us whether the economy is shrinking or expanding yoy, mom or qoq. What we need to determine are growth rates in order to predict how the central bankers or market participants will react. So what do we mean by the growth rate? An example of the annualized growth rate is calculated as shown in the excel sheet. A simple way to think about the growth of a number is to take the difference between the new value and the old value to determine how much that number has grown. Now in order to find the percentage growth we simply divide the difference by the old value. So now growth is simply (new value – old value)/old value. Growth rates are also annualized so we can make fair comparisons. So we can basically compare apples with apples and not apples with oranges. In our example the growth rate is already an annual number so we need not annualize this. However if we had a quarterly figure we would need to annualize this number in order for us to make comparisons. So to make it annual we simply multiply by 4 since there are 4 quarters in a year.