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According to the latest gross domestic product data, the U.S. economy expanded faster than expected in the fourth quarter, at a 3.5% pace compared to the forecasts for 3.0%. This gain followed subpar growth in the previous two quarters.

These fourth-quarter data are strong enough to keep the Federal Reserve on the sidelines. Although growth did accelerate, those who are bearish on the economy will seize upon some important factors in the GDP report:

  • A decrease in business spending
  • Sharp weakness in residential investment
  • High government spending
  • Lackluster nominal personal spending.

If the fourth-quarter GDP gain had been purer -- in other words, if it had occurred in the absence of the aforementioned factors -- speculation about the possibility of a renewed bout of rate hikes would surely have developed after the release of the report.

I don't mean to discredit the fourth-quarter gain completely, and I have been upbeat about growth, but the reported gain must be watered down to some degree. Let's take a look at each of the four factors listed above and how we can interpret the data.

Business Spending

First, business spending fell during the quarter, with spending on equipment and software falling at a 1.8% clip. That's the second decline in three quarters and the largest since the fourth quarter of 2002.

The weakness is likely a response to the anemic GDP reports of the past two quarters, and businesses were probably concerned about growth prospects in light of the sagging housing sector and high energy costs that existed at that time. Business spending will probably pick up in the first quarter in response to the decline in energy costs and signs of bottoming in home sales.

Residential Investment

Another negative in the report is the sobering figure on residential spending, which subtracted 1.2 points from GDP and fell for a fifth consecutive quarter, by 19.2%. That follows decreases of 18.7% in the third quarter and 11.1% in the second quarter. The fourth-quarter decline was the highest since 1991, but seems likely to be the nadir for the cycle. Nevertheless, the decline is large enough to make clear that significant downside risks to the economy remain because of weakness in the housing sector.

Government Spending

The bear camp will surely note the relatively large contribution from the government sector, where spending increased 3.7%. The federal government led the way with a 4.5% gain in spending, which was boosted by an 11.9% gain in spending on national defense. State and local spending increased 3.3%. Overall, the government sector added seven-tenths of a percentage point to the fourth-quarter GDP gain.

The contribution should not be entirely dismissed, however, as it is likely to remain a feature throughout 2007 because of favorable budget situations at the federal, state and local levels. For example, the National Governors Association is forecasting nominal state spending to increase at a 7% clip in 2007, comfortably above its 30-year average of 6.4%.

Personal Spending

A negative that isn't so readily apparent in the headlines relates to the pace of personal spending. On the surface, the figure looks solid, increasing 4.4%. The problem, however, is that it reflects a gain of just 3.6% in nominal spending because the personal consumption deflator fell 0.8%, its first decrease since 1961 and the largest decline since 1954, according to Market News.

This means that if the inflation rate for the quarter were at a normal level, say, up 2.0%, personal spending would have seen a very small gain of just 1.6% for the quarter. (I get this by subtracting 2.0% from 3.6%.)

The low level of nominal spending, which was the weakest in four years, reflects strain on the consumer. This figure represents the total amount of money that consumers spent during the quarter, a tally that looked good only because they caught a break with the decline in energy costs. Had energy costs increased, it would have produced a much different result. For context, nominal spending in the overall economy has increased at a pace of 5.6%; it increased at a pace of 5.0% in the fourth quarter.
Tony Crescenzi is the chief bond market strategist at Miller Tabak + Co., LLC, and advises many of the nation's top institutional investors on issues related to the bond market, the economy and other macro-related issues. At the request of the Federal Reserve, Crescenzi is a regular participant in the board's Livingston Survey of economic forecasters. He is also the author of The Strategic Bond Investor. At the time of publication, Crescenzi or Miller Tabak had no positions in the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Crescenzi also is the founder of Bondtalk.com, a popular Web site covering the bond market and the economy. Crescenzi appreciates your feedback; click here to send him an email.

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