Thursday, October 30, 2008

GDP Deflator De-Mystified

The GDP Deflator is the rate required to convert nominal GDP to real GDP. In Q2, the nominal rate was 3.9% and the real was 2.8%, thus the GDP Deflator was 1.1%, at a time when inflation was ticking up at around 5%.

Ed over at Credit Writedowns writes:

The GDP deflator was clocking in at an annual 4.2% clip, whereas last quarter it was a preposterous 1.1% and in Q1 it was a hardly more believable 2.6%. I have been looking for ways to explain this increase in the deflator and can't. If anyone knows, please write me and tell us.
I previously broke down the Q2 GDP Deflator here, but let me dive a little deeper.
Before we can fully understand why the GDP Deflator was so low in Q2, we first need to step back and think about what makes up GDP:

The key to understanding the 1.1% GDP Deflator in Q2, is the subtraction of imports. Think back to what the biggest story related to imports was in Q2... the spike in the price of oil of course.
This means the nominal import figure needed to be drastically reduced, to account for all that inflation, in order to turn that figure into the real contribution. Petroleum imports needed to be reduced by 24% in the quarter alone to account for the inflated price. Now, remember the negative sign in front of imports? This means that the contribution of this 24% rate needed to be removed from the GDP Deflator, not added (again... GDP is production in the U.S. only).
Take the inflated price of almost all imports in Q2 and you can see why this had such a large impact. In Q2, that import figure contributed a massive –4.6% to the GDP Deflator in total. Without this figure, the GDP Deflator was a much more understandable 5.7% figure versus the 1.1% number we saw.

I still don't buy the GDP figures for Q2 for other reasons (and I will post shortly some issues I have with Q3), but it is important to understand how it all works...

I traded a few emails with Ed and his final email really describes the process too well not to post:
What I imagine they do is:
1. Collect the data (quantity and price) to arrive at a nominal number that they seasonally adjust for all of the components of the GDP like imported goods for example.

2. They take this seasonally adjusted nominal figure and match it with a price change figure which is the deflator to get real GDP changes in sub components of GDP. This is how one gets from nominal goods imports to real goods imports.

3. They also then roll up these numbers in a weighted average into a GDP deflator. As imports are subtracted from GDP, that particular item actually DECREASES the GDP deflator.

4. The GDP deflator can then be used to take nominal GDP, which is an aggregation of the nominal sub-components, in order to compute Real GDP.