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Last Thursday the government reported that the U.S. economy shrank by 1.4% on an annual basis during the first quarter of 2022. The benchmark used to summarize the state of the incredibly complex and dynamic economy is called Gross Domestic Product, or GDP. Markets rise or fall on the eagerly anticipated release of this number every quarter, while policymakers and businesses rely upon the data in formulating plans. A deeper understanding of GDP and its composition can also help consumers interpret the complicated news flow and its impact on our own decision-making.

Let's begin with a definition. gross domestic product is the market value of all the goods and services produced by the nation's economy less the value of the goods and services used up in production. Think of it as the net value added by the economy during a fixed period, measured quarterly. In practice, GDP is calculated by estimating the total value of all "final" goods and excluding intermediate production to avoid double counting. For example, the cost of a new car is counted while the individual prices of the engine, tires, and transmission are not. The U.S. GDP was $24.4 trillion in the first quarter at an annual rate.

The Bureau of Economic Analysis, or BEA, reports GDP at annualized rates. The actual output of the U.S. economy for Q1 of 2022 was $6.1 trillion but is multiplied by 4 and reported as an annualized number. The same is true for the percentage changes from quarter to quarter: the 1.4% decline in Q1 is reported at an annualized rate to allow comparison of a given quarter with previous periods.

GDP is a conglomeration of many thousands of data points but is broadly categorized into four broad components. Much of the data is reported to BEA by other departments of the federal government, but some information is furnished by private sources like the National Association of Realtors, JD Power, and so on.

Personal consumption, often called consumer spending, comprises the goods and services purchased by households like haircuts, refrigerators, groceries, doctor visits and the like. Consumer spending accounts for the vast majority of GDP, typically in excess of two-thirds of the total. Personal consumption increased by 2.7% during the quarter at an annual rate, the seventh straight quarterly improvement since the depth of the pandemic recession.

Gross private domestic investment includes business spending within the United States on fixed assets like land, buildings and equipment as well as inventory and makes up about 20% of GDP. This category also includes single and multi-family housing purchases. Investment spending slowed from the previous two quarters but still registered a 2.3% gain. This number is highly variable quarter to quarter.

Government spending encompasses all goods and services purchased by government entities at the Federal, state and local level. Government spending declined at an annual rate of 2.7% to 17% of GDP due to reduced defense outlays and the expiration of some covid-related spending programs.

Net exports (exports minus imports) were the biggest drag on GDP for Q1. If imports exceed exports (as they typically do), the result is called a trade deficit and the amount of the deficit is subtracted from GDP. The trade deficit reached an all-time high in Q1, as exports fell while merchants accelerated orders for imported goods to restock depleted inventories.

The inputs are compiled by career civil servants and the resultant estimates of GDP are released in three tranches approximately one month apart, with each successive revision including more accurate and complete information. The first release is the roughest estimate as it takes several weeks for all the data to be reported to BEA. The 1.4% decline for the first quarter of 2022 is the first estimate and will be refined over the next two months. Historically, subsequent revisions average about percentage point in either direction as more data becomes available.

It is also useful to note that the headline number that gets so much attention is the change in "real GDP" after adjusting for inflation. For the 1st quarter, current dollar or nominal GDP increased by 6.5% at an annual rate, but inflation as computed by the BEA was 7.8% for the quarter, so the "real" inflation-adjusted growth rate was negative.

Over the past 30 years, real GDP growth has averaged around 2.5% annually. For context, GDP fell by 3.4% during 2020 and rebounded by 5.7% in 2021.

While the decline in GDP surprised most forecasters, the data is extremely noisy due to extraneous factors like the supply chain disruptions and the Russian aggression against Ukraine, so economists are cautious about extrapolating from one quarter. Still, understanding the composition and importance of GDP can help consumers keep a finger on the pulse of the U.S. economy and better understand the news flow.

Christopher A. Hopkins is a chartered financial analyst in Chattanooga.

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