Real GDP declined at an annualized rate of 3.8 percent in the fourth quarter, which was not as bad as the consensus forecast had anticipated. However, the economy is weaker than it appears. Indeed, the rise in inventories in the fourth quarter suggests that the economy will contract at a faster pace in the current quarter.

GDP Head Fake in the Fourth Quarter

U.S. real GDP declined at an annualized rate of 3.8 percent in the fourth quarter (see top chart). Although the decline in GDP was the largest contraction since the first quarter of 1982, the outturn was not nearly as bad as the 5.5 percent plunge that the market consensus forecast had anticipated. Is it time to break out the champagne and start celebrating the incipient economic recovery? Hardly.

The real surprise in today's report was the unexpected increase in real inventories, which rose $6.2 billion in the fourth quarter following a $30 billion drawdown in the third quarter (see middle chart). Inventories made a positive contribution to GDP growth equal to 1.3 percentage points in the fourth quarter. Without the build in stocks, overall GDP growth in the fourth quarter would have been much weaker.

Indeed, final sales to domestic purchasers, which include personal consumption expenditures (PCE), fixed investment, and government spending, plunged 4.9 percent in the fourth quarter (see bottom chart). Real PCE tumbled 3.5 percent and fixed investment spending cratered, down 20 percent. Within fixed investment spending, purchases of equipment and software plunged nearly 28 percent – the sharpest quarterly decline in fifty years - and residential construction continued its freefall, down another 24 percent. As if to rub salt in the wound, gross exports plunged nearly 20 percent, a by-product of recession in most foreign countries. However, gross imports also tanked (down nearly 16 percent), so there was little overall effect on GDP from net exports.

The only bright spot in domestic spending was the 1.9 percent rise in government consumption expenditures. A modest decline in state and local spending was offset by an increase in federal government spending. As the Obama stimulus package hits the economy in the quarters ahead, government spending will continue to rise.

Inventory Rise in Fourth Quarter Should Be Reversed in First Quarter

In sum, today's GDP report is no cause for celebration - the economy is even weaker than the headline growth number would suggest. In addition, the apparent inventory build-up in the fourth quarter sets up a big drawdown of stocks in the first quarter that will weigh significantly on GDP growth. Prior to today's report, we had thought that the weakest quarter in the current cycle would be the fourth quarter of 2008. However, with mounting job losses weighing on consumer spending, businesses axing their capex plans and a big decline in inventories looming, an even sharper contraction in the economy seems to be shaping up in the first quarter.