The estimate is higher than my forecast by a fair amount actually, but in the grand scheme of forecasting, forecast errors, and the direction of change, I am reasonably happy. I had forecasted the increase in growth with trepidation because the economic fundamentals remain weak.

The fourth quarter data implies that the economy grew 1.7 percent in 2011, compared with 3.0 percent in 2010.

What were the drivers of the increase in fourth quarter growth? Consumption and Investment expenditures both rose, $50b and $80b respectively, trade was little changed, and government expenditures fell about $30b.

Investment expenditures are driven by a four main components, business structures, equipment and software, residential, and inventory investment. All of these components are volatile, but one of them, inventory expenditures, is super volatile. Sure enough, about $55b of the $80b investment expenditure increase was due to inventory investment. I hope that the shelf-stocking was not overdone for if it was, there would be a slowdown in inventory investment this quarter.

Another interesting movement within Investment was residential, up at an annualized growth rate of about 11 percent. While residential investment in states like Nevada, California, Florida remain at historic lows, it is booming in states like North Dakota, Oklahoma, and Texas. We can thank the middle part of the country for this source of growth.

The $30b pullback in government expenditure breaks down to a $20b decline in Federal and a $10b decline in State/local expenditures. The Federal change was due to a defense spending contraction, as non-defense expenditures rose slightly.

Inflation, as measured by the GDP deflator, fell dramatically from 2.6 percent in third quarter to 0.4 percent in fourth quarter. Subdued inflation in a time of relatively high unemployment is a good thing, as it helps those unemployment or partially-unemployed households manage expenses.

The BEA measure of the personal savings rate fell from 3.9 percent in third quarter to 3.7 percent in fourth quarter. This worries me, as household debt levels are still high. I have argued this before and will do it again: consumption in an era of high household debt does not help the economy. What is needed is savings and investment. Future growth depends on it.

The saga of the Great Recession continues. Over six million people have been unemployed for more than 27 weeks, and job growth may be slow enough in the next few months that the unemployment rate rises again. Major revisions to GDP, released in late July, show that from 2007 to early 2011 the United States economy was weaker than previously understood. The consensus forecasts for the United States and World economies have been revised down.

However, these aspects, negative as they are, are not currently as important to near-term growth as the impact from the probable reduction in the number of countries in the European Union. Bill Watkins discusses the European crisis earlier in this blogspace.

The economy grew much more slowly during the first half of 2011 than during 2010. One big reason is that consumption growth slowed. I think that consumption growth will remain relatively weak for at least the remainder of this year. This is in part because I think that wealth accumulation and income growth will be weak. At this point, low interest rates do not help much. But, there is more to the consumption story. Household debt levels, despite subsiding from their bubble highs, are still too high. If households continue to reduce their debt, consumption growth will remain muted. While near-term growth suffers a bit when households save more, the long-run health of the economy is improved. Economic recovery from major asset price deflation has never been quick or pleasant, and this time is no different. Indeed, real estate prices remain low and equities are down from the first half of this year.

We forecast growth in inventory investment and in equipment/software investment. However, we are bearish on commercial structures and housing.

We forecast that government expenditures growth, which includes state and local, will remain slightly negative for the remainder of this year. It appears that governments at all levels have bumped into their budget constraints.

We forecast that trade will produce a slight drag on growth, with the trade balance deteriorating slightly. This is due to slowing world growth.

What about the Fed? They have conducted the first of their two-day policy meeting today. I expect that the Fed will announce a policy change tomorrow which could include an attempt to push longer-dated Treasury rates down and, less likely, a reduction in the interest rate on excess reserves. The market has appears to have priced in a reduction in longer rates. Despite this boost, equities are not doing very well.

A reduction in the interest rate on excess reserves would provide greater incentive for banks to loan, and this is the better idea of the two. However, this policy may not provide much benefit. The problem is that many small businesses and households are reducing debt, not increasing it.

As a result of the above mentioned forecast of the major components of GDP, our GDP forecast is bearish, significantly under the Wall Street Journal consensus of 55 forecasters for the second half of 2011 and the first half of 2012.

With the recent and forecasted weak United States and World economic growth and with a slowdown in commodity price growth, our forecast indicates that inflation will not be a problem. The secular trend in rising inflation since March will likely be broken soon, probably as soon as the September data is released in mid-October.

Inflation will be the least of the Fed’s worries during the second half of 2011.

BLS data show that February year-on-year growth of the Core CPI has reached 1.1 percent, up from the recent low of 0.6 set October 2010.  All items CPI growth has reached 2.1 percent. While energy was the largest driver, most of the other CPI categories also contributed to the rise.

What are the indicators for March?  March import prices were up, oil prices were up, and the next employment cost index report, due out April 29, will likely show some gains.  Any wage and salary gains will help this job-weak recovery, but will also contribute a bit to inflation.

What does this mean?  Despite ongoing fundamental economic weakness, we have likely moved past an episode where Deflation was a valid concern. 

As an aside, it also has an implication for our real interest rate forecast.  Many nominal interest rates, especially longer Treasuries, are rising.  Thus far, we have about a 100 basis point rise in the (nominal) ten-year Treasury in the last six months.  We had a similar rise in the All items inflation rate in that same time whereas the Core inflation rate increase was about half that.  In the case of the All items deflator of the Treasury yield, the implied real rate has not changed, but with the Core deflator, the implied real rate rose by about 50 basis points.  Either way, we have yet another fundmantal indicator, real interest rates, that is not improving. 

While I no longer characterize the situation as a “Good-deflation Equilibrium” we have not moved very far from that equilibrium at this point.  However, we may be in the process of moving to an equilibrium with higher inflation than the February level.  There are reasons to believe that the current course of debt-financed expansionary fiscal policy will lead to higher future inflation.  This course of fiscal policy will likely be maintained through 2012.  It is likely we will get to a point in 2011 or 2012 where the Fed will consider raising the Federal Funds Target rate.

I think Fed policy has been too tight. Instead of paying interest on excess deposit, they should be charging a fee. Of course, many disagree and worry about inflation, and that is what I thought I was reading as Shelton proceeds with her thesis that the Fed’s policy may be fueling a new asset bubble. This is pretty standard stuff, boringly standard in fact. I was about to quit reading and go on to something else when I came to a paragraph that stopped me cold:

“Deflation is seen as the bugaboo of Keynesian economics. But it can actually serve to spur economic activity as lower prices enable struggling consumers to get back in the game, and enterprising individuals can build businesses using tangible assets that yield valid profits.”

That paragraph is breathtaking, so wrong on so many levels, so counter to what we know to be true. I couldn’t believe that an economist would say that. So, I looked for her tag line. Sure enough, it says she’s an economist. I did a web search. She’s got at least one book out. She’s in the WSJ frequently. She’s all for a gold standard.

Shelton received her Ph.D. in Business Administration at the University of Utah, and she’s a professor at the Duxx Graduate School of Business at Monterrey, Mexico. One observer—goes by Federalist on the web, but I couldn’t find a name—described her as having few credentials. I don’t think that is exactly true. She has impressive credentials, just not as an economist.

Let’s correct her paragraph:

No one is going to mistake me for a Keynesian, but I’m certain that deflation is bad. Economists in general, not just Keynesian, know deflation is bad. I don’t know of one credible economist, from a top 50 school, with a Ph.D. in economics, who believes that deflation is not bad.

Shelton goes beyond saying deflation is not bad. She claims deflation is good, stimulative, spurring economic activity, “enabling struggling consumers to get back in the game.” Amazing.

Here’s the story on deflation: As prices fall, no one has an incentive to purchase anything, the cost will be less tomorrow; consumption and investment decline. Borrowers pay with deflated dollars, making real interest rates very high, again leading to less investment and consumption. Wages don’t adjust quickly, leading to unemployment, 25 percent in the depression. Asset values decline, but debts become more burdensome, leading to credit defaults and over-leveraged banks, businesses, and consumers. Lending, borrowing, consumption, investment, and economic activity decline.

One problem of smart people pontificating outside their field is that they come up with ideas that sound good, don’t hold up to serious analysis. Economists have performed a huge amount of research on inflation and deflation, empirical research and theoretical research. The profession has rejected the thesis that deflation is good. The risk is that someone with authority listens to someone like Shelton and tries to implement her recommendations. That would be tragic. Bad policy leads to a bad economy, and the costs of a bad economy are immense and not just financial. Serious recessions change lives, usually for the worse. Careers, families, and lives are destroyed. It is a shame that Shelton has a mouthpiece as big as the Wall Street Journal.

However, inflation is not inevitable. For inflation to occur, increases in the monetary base have to be translated to an increase in money supply. This is the money multiplier that we teach in elementary macro-economics, and it depends on bank lending, something that is just not happening. Even if the money supply increases, velocity declines could offset the inflationary impacts.

We are seeing an alarming increase in deflation around the world. The BBC reported today that Japanese prices have fallen 8.5 percent in the past year. Prices have also been falling in Germany, Spain, Britain, Ireland, and Switzerland.

It is virtually impossible to imagine a recovery if the United States slips into deflation. So far, we’ve had small increases in prices. Let’s hope that continues.