Schwab Guide To Economic Indicators: Gross Domestic Product

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Schwab Guide to Economic Indicators: Gross Domestic Product
by the Schwab Center for Financial Research
December 10, 2007

What is it?
Gross domestic product, or GDP, is the total market value of all domestically produced goods and services.

How is it calculated?
GDP is the combined total of consumption (durable goods, nondurable goods, and services), government spending (federal, state and local), investments (residential and nonresidential), and net exports (exports less imports). GDP is most commonly discussed in an inflation-adjusted form known as real GDP.

How is it used?
Because GDP is widely viewed as the most comprehensive measure of U.S. economic activity, economists and market analysts use it in part to help gauge overall corporate profits. Furthermore, GDP is one of the primary reports the Fed monitors in setting interest rates.

The Fed uses another calculation to determine the maximum, non-inflationary growth rate of GDP, considered to be near 2.5% to 3%. This calculation is based on the long-term annual rate of labor force growth and the annual rate of productivity growth. While the less-volatile annual labor force growth rate has historically been near 1%, the sustainable productivity growth rate is now generally thought to be in a range of 1.5% to 2%. These total 2.5% to 3%. However, short-term fluctuations in the labor force and productivity can temporarily produce correspondingly different potential rates of GDP.

GDP is considered output. Yet the primary monetary policy mechanism for seeking price stability is to balance aggregate supply with aggregate demand—not output. Demand, also known as real final sales, can be determined by subtracting the inventory change from GDP. If inventories decline, for example, it would reflect increased demand—therefore, real final sales (demand) would be higher than GDP (output). Conversely, if inventories increase, this stockpiling would result in a demand figure below GDP. While GDP is important, it's also useful to monitor real final sales.

The GDP report also contains the Fed's preferred price gauge, known as the Personal Consumption Expenditures (PCE) chain-type price index.

What is its relative importance?
High. Despite being a backward-looking indicator, GDP is a comprehensive account of output, demand, inflation, and has a big effect on corporate profits and monetary policy.

What impact does it have on the market?
Outcomes relative to forecasts are more important than the "2.5% to 3%" sustainable range and the Fed's year-end projection. Why? Since many of the components that comprise GDP (retail sales, durable goods orders, government spending, etc.) are widely known prior to the report's release, the market most likely has already adjusted to what it thinks the number could be.

The relative tautness of (or slack in) the economy is also important. Typically, GDP that exceeds expectations can drive up projections for inflation, thereby pushing bond yields higher (bond prices lower). Such moves typically hurt the relative valuation of stocks, so they also suffer. Yet, to a degree, GDP that exceeds expectations can be less harmful to stocks if it occurs at a time when the economy exhibits slack conditions, with inflation relatively low. Under that scenario, the hope that corporate profits might also do better because of higher-than-expected GDP can minimize the generally negative impact on stocks, even if investors and analysts presume the Fed will raise rates faster.

When is it released?
GDP is typically released near the end of the month, three times per quarter: the initial report followed by two revisions. In order, the names assigned to these are advance, preliminary and final. You can find the latest GDP numbers at the Bureau of Economic Analysis.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. Data contained here is obtained from what are considered reliable sources; however, its accuracy, completeness or reliability cannot be guaranteed.

(2007-5771)

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