Key to GDP: Inventories, Capital Spending - TheStreet

Gross domestic product reports are often old news. Because they're made up primarily of data that already have been released, they tend to be relatively easy to predict.

This time around, it's a little bit different. Wednesday's fourth-quarter GDP report should tell us a lot about the U.S. economy that we don't already know.

Most economists expect GDP to contract for a second-straight quarter in the fourth quarter, in large part because of a steep drop in inventories after Sept. 11. On average, estimates call for a 1.1% decline, compared with a 1.3% drop in the third quarter. But estimates range from a 2% contraction to 1% growth.

Fearing demand would tank in the wake of the September terrorist attacks, businesses scaled back production, slashed jobs and cut work hours. When demand was stronger than they expected, they were able to clear out inventory at a rapid pace. Just how rapidly is the biggest point of contention.

"More so than usual, there's a lot of uncertainty about where the number will come in, because of uncertainty about how dramatically inventories were liquidated and how sharply capital spending declined," said Peter Kretzmer, senior economist at Banc of America Securities. "These two components are also going to be the main reasons for a decline this quarter."

Consumer spending accounts for the lion's share of the U.S. economy -- about two-thirds of total activity. While consumers have curtailed their spending since October, they haven't retrenched as much as economists feared. Car sales jumped thanks to cheap financing deals. Retail sales grew 2.9% in December, vs. 4.7% growth in November and an 8.5% increase in October.

Inventories and capital spending account for a far smaller share of the economy, but they're key to a turnaround and are much harder to pin down. Unlike most recessions, which are led by slowing consumer spending, this one has been driven by a slump in business spending. If inventories hit the floor and capital spending held firm in the fourth quarter, remaining flat or declining slightly from the third quarter, the U.S. economy will be in a great position to start growing, economists said.

"The momentum of thought is now turning from recession to recovery," Kretzmer said. "When we look backward in time, the inventory liquidation is really important because it tells us the degree to which we can expect a reversal to occur in coming quarters. A more severe decline means a stronger rebound."

Some economists estimate that inventories were reduced by as much as $140 billion during the quarter in annualized terms, which would be the largest decline since World War II and would lop 3 percentage points off of GDP for the quarter. Other economists are forecasting a decline of just $85 billion. On the capital spending front, economists expect that investments in software and equipment, as well as real estate, declined anywhere from 5% to 20%.

The widely divergent forecasts are based on differences in estimates of value vs. volume, said Jim Glassman, senior U.S. economist at J.P. Morgan Chase. Because the monthly data are calculated in nominal terms and are heavily weighted toward technology, they might have been distorted by wide price fluctuations on high-tech equipment at the end of last year.By comparison, the government's GDP data filter out distortions related to inventory valuation. In addition, the December business inventories report isn't released until the middle of next month.

According to the Commerce Department's

durable goods orders report released Tuesday, orders for computers and related products fell 2.6% in December, while communications equipment orders dropped 0.9%. Inventories of durable goods fell for the 11th-consecutive month in December, dropping 0.4% to $284.7 billion.

Glassman is looking for a drop of 5% in equipment and software spending for the quarter, but he said he could be way off. "All we know is the dollar value of the shipments today," he said. "What we don't know is what's going on with prices. In the tech area, there has been a huge decline in prices, so there have been big nominal shifts."

Another big factor is government spending, which contributed about 15% to economic growth in the third quarter. Kretzmer is expecting a 4% annualized increase in federal, state and local government spending in the fourth quarter. Based on two months of data, and an estimate for December, he expects that net exports subtracted one-half of a percent from GDP, as export growth slowed more rapidly than import growth.