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Why a contraction in the U.S. economy is not a sign of recession

Workers prepare a new housing lot at a construction site in Alexandria, Va.


The surprise retreat of the U.S. economy at the end of 2012 was a blip, rather than a harbinger of recession.

Federal Reserve Board chairman Ben Bernanke and many economists showed little concern Wednesday following a report that the economy unexpectedly shrank at an annual rate of 0.1 per cent in the fourth quarter.

"This isn't the start of a new recession," insisted Paul Ashworth, chief U.S. economist at Capital Economics in Toronto, calling it "the best-looking contraction in U.S. GDP you'll ever see."

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Economies do not typically contract unless they are in recession.

This "pause" was caused mainly by "weather-related disruptions and other transitory factors," Mr. Bernanke and his colleagues on the Fed's rate-setting open market committee concluded as they wrapped up the first meeting of the new year.

But the sudden drop in gross domestic product underscores the fragile nature of the U.S. recovery. The jobless rate remains stubbornly high, and businesses are still holding back on hiring and investments. The Fed reiterated its vow to keep interest rates ultra-low by flooding the financial system with cash until the job market improves.

Economists blamed October's Hurricane Sandy, which devastated a wide swath of the U.S. East Coast and wreaked havoc on business inventories, for the GDP drop. The other major cause was a 22.2-per-cent fall in defence spending on the eve of the "fiscal cliff." Combined, the two events knocked nearly three percentage points off GDP.

The 0.1-per-cent GDP decline is a jarring reversal from the 3.1-per-cent annual growth rate in the third quarter, the Commerce Department reported Wednesday. It was the first contraction since the 2007-09 recession. Economists had expected GDP growth of 1.1 per cent.

The estimate could change as the Commerce Department refines its initial estimate with more complete information in the coming months.

Analysts said the decline in GDP will probably prove to be an aberration from the steady expansion that has been taking root in the United States. "There really is cause to downplay the contraction," Toronto-Dominion Bank senior economist James Marple said. "The private domestic economy in the U.S. – consumers and businesses – actually performed reasonably well, better in fact that they did in the previous two quarters."

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The sudden shrinking of the U.S. economy is a powerful reminder of how a precipitous drop in government spending cuts can quickly choke growth. The U.S. Congress and the Obama administration struck a deal in early January that avoided a combination of steep tax hikes and spending cuts, known as the "fiscal cliff."

Defence spending artificially inflated the third quarter and then dragged down the fourth. Defence spending alone shaved an estimated 1.28 percentage points off the GDP in the fourth quarter. In the end, Congress deferred the massive spending cuts. Analysts said the United States is likely to return to steady growth in 2013.

For the year as a whole, the economy grew by 2.2 per cent, an improvement on the 1.8-per-cent pace in 2011.

John Silvia, chief economist at Wells Fargo Securities in Charlotte, N.C., said underlying growth is much more stable than the fourth-quarter GDP would suggest. But the economy has settled into "a slower pattern" than in past economic recoveries, which may disappoint many investors. He pointed out that personal consumption was up 2.2 per cent in the fourth quarter and disposable income was up 1.5 per cent.

One member of the Fed's 12-member committee voted against the decision to keep the central bank's easy-money policies in place: newly arrived Kansas City Fed President Esther George. Richmond Fed President Jeffrey Lacker, who voted against every decision last year, isn't on the committee this year.

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