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Inflation was low because oil prices surged
In GDP math, sometimes one plus one equals zero
By Rex Nutting, MarketWatch
Last Update: 1:56 PM ET Oct 31, 2007
WASHINGTON (MarketWatch) -- As odd as it sounds, the government reported that inflation was at a four-decade low in the third quarter, primarily because import oil prices rose so much.
If you don't understand that, welcome to the confusing world of national income accounting, where up sometimes is down, and where sometimes one plus one can equal zero.
The simple explantion:
Because of the way the government counts and reports the numbers, real-life inflation was understated and growth was overstated.
The economy didn't really grow 3.9%, and inflation really wasn't 0.8%. The numbers aren't as good as they look.
The complicated explantion:
When reporting on gross domestic product, the government counts up all the economic activity in the country, including consumer spending, business and residential investment, and government spending and investment. Then it adds all the exports, and subtracts all the imports. The final total is gross domestic product.
The fact that imports are subtracted is an important detail, so remember it.
Of course, all this counting is done in current dollars, the kind you and I have in our pockets, the kind that lose value every day to inflation. In order to gauge how much of the increase in spending and investment during a quarter was due to real growth and how much to inflation, the government deflates the total number of dollars by its estimate for how much prices rose.
In the third quarter, the government estimated that current dollar spending and investment increased at a 4.7% annual rate. After subtracting 0.8% for inflation, the real growth rate was 3.9% in the third quarter. See full story.
How does the government estimate inflation? The same way it estimates growth, by looking at individual price changes for consumer spending, business and residential investment, and government spending. Then it adds the price changes for exports and subtracts the price changes for imports.
It subtacts import price changes. Remember that.
Sometimes the mechanical formula produces some "quirky, nonintuititive relationships," said Shelley Smith, who's in charge of figuring the price index for the government's Bureau of Economic Analysis.
Most of the time, the government's formula doesn't produce any weird numbers, because the mathematical quirks all cancel each other out. But in the just concluded third quarter, it did produce quirky numbers that don't accurately reflect reality, even though they are correct from an accounting point of view.
Imported crude oil prices rose from an average of about $69 a barrel in the second quarter to $75 in the third, but wholesale gasoline prices fell by about 10 cents to $2.07 a gallon. Imported prices for energy rose, but domestic prices didn't.
In the government's accounting, prices of imported goods rose at a 10.3% annual pace in the quarter, but that increase was subtracted when figuring the economy-wide price index. Import prices subtracted 1.3 percentage points from inflation in the third quarter. With domestic prices rising slower than they had previously, it was enough to push inflation to four-decade low of 0.8%.
The accounting is right. But it's not reality.
Inflation was low because oil prices surged
In GDP math, sometimes one plus one equals zero
By Rex Nutting, MarketWatch
Last Update: 1:56 PM ET Oct 31, 2007
WASHINGTON (MarketWatch) -- As odd as it sounds, the government reported that inflation was at a four-decade low in the third quarter, primarily because import oil prices rose so much.
If you don't understand that, welcome to the confusing world of national income accounting, where up sometimes is down, and where sometimes one plus one can equal zero.
The simple explantion:
Because of the way the government counts and reports the numbers, real-life inflation was understated and growth was overstated.
The economy didn't really grow 3.9%, and inflation really wasn't 0.8%. The numbers aren't as good as they look.
The complicated explantion:
When reporting on gross domestic product, the government counts up all the economic activity in the country, including consumer spending, business and residential investment, and government spending and investment. Then it adds all the exports, and subtracts all the imports. The final total is gross domestic product.
The fact that imports are subtracted is an important detail, so remember it.
Of course, all this counting is done in current dollars, the kind you and I have in our pockets, the kind that lose value every day to inflation. In order to gauge how much of the increase in spending and investment during a quarter was due to real growth and how much to inflation, the government deflates the total number of dollars by its estimate for how much prices rose.
In the third quarter, the government estimated that current dollar spending and investment increased at a 4.7% annual rate. After subtracting 0.8% for inflation, the real growth rate was 3.9% in the third quarter. See full story.
How does the government estimate inflation? The same way it estimates growth, by looking at individual price changes for consumer spending, business and residential investment, and government spending. Then it adds the price changes for exports and subtracts the price changes for imports.
It subtacts import price changes. Remember that.
Sometimes the mechanical formula produces some "quirky, nonintuititive relationships," said Shelley Smith, who's in charge of figuring the price index for the government's Bureau of Economic Analysis.
Most of the time, the government's formula doesn't produce any weird numbers, because the mathematical quirks all cancel each other out. But in the just concluded third quarter, it did produce quirky numbers that don't accurately reflect reality, even though they are correct from an accounting point of view.
Imported crude oil prices rose from an average of about $69 a barrel in the second quarter to $75 in the third, but wholesale gasoline prices fell by about 10 cents to $2.07 a gallon. Imported prices for energy rose, but domestic prices didn't.
In the government's accounting, prices of imported goods rose at a 10.3% annual pace in the quarter, but that increase was subtracted when figuring the economy-wide price index. Import prices subtracted 1.3 percentage points from inflation in the third quarter. With domestic prices rising slower than they had previously, it was enough to push inflation to four-decade low of 0.8%.
The accounting is right. But it's not reality.
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