The Commerce Department reported that gross domestic product actually shrank in the last quarter of 2012. The drop was small, one-tenth of a percent. But it was still the first time economic output had fallen in three-and-a-half years. Government spending dropped, most dramatically in the defense sector.

　　The report, though, also contained some positive developments. Consumer spending and business investment were both up. And yesterday, the so-called Case-Shiller index found that housing prices grew in 20 major cities by an average of 5.5 percent over the previous year. It was the biggest gain in six years.

　　We talk it through now with Joel Naroff, an economist who heads his own consulting firm in Pennsylvania, and Roben Farzad, a senior writer with Bloomberg Businessweek.

　　Joel Naroff, let me start with you. This really was a surprise to most people. What happened? What's behind the contraction last quarter?

　　JOEL NAROFF, Naroff Economic Advisers: Well, it was largely the government's doing between the largest cutback in 40 years in defense, which took well over a percentage point of growth out, and the fears of falling off the fiscal cliff, which caused businesses to be really, really cautious in their inventories and they fell dramatically, taking another percentage point or more out.

　　Those were the basic reasons. But, you know, as was noted, when you look at the fundamentals and the details of what's going on in businesses and households and housing, those are all solid. And I think that really says this economy has forward momentum, despite what the numbers seem to indicate.

　　JEFFREY BROWN:All right, well, I want to come back to momentum, but first—the first two points you made, first about government the cuts, and we have heard a lot about that, but the companies restocking at a slower rate, what does that—what's behind that? What does that tell you?

　　JOEL NAROFF: Well, I think really what happened was that businesses were really cautious, uncertain about whether or not we'd wind up going off the fiscal cliff.

　　And they made some very short-term decisions. It's easy just to keep the warehouses essentially empty. If we don't go off the cliff, they can refill them quickly. And so I think what happened during the end of the year was they just ran things very, very close to the vest, and now I think we will see in the first part of this year that they will have to rebuild it, and that will add to growth.

　　JEFFREY BROWN:Well, Roben Farzad, as we heard from Kwame Holman, the Federal Reserve referred to this as a pause in the economy. What do you see?

　　ROBEN FARZAD, Bloomberg Businessweek: The Federal Reserve has its foot on the gas, the pedal to the metal.

　　It is targeting unemployment now with inflation so benign. After all, unemployment is still perilously close to 8 percent. It's been above, I think, 7.5 percent for the longest stretch in the post-World War II period. And the Federal Reserve realizes there is so much slack in the

　　system, it's going to keep going out there, keep rates at painfully low levels to support homeowners, people who want to take out mortgages.

　　Obviously, corporations that can borrow at record low levels are loving this. And, oh, by the way, the stock market is at near record levels. I don't think many people on the street would appreciate that, but when and if they do remember their 401(k) log-ins and they go in there, they're bound to have a positive wealth effect for them.

　　JEFFREY BROWN:Well, tell us, Roben. On that, there have been report that small investors have been getting back into the market. They're a little bit more confident, I guess. Is that the case and what does that tell you?

　　ROBEN FARZAD: It's a paradox, in that small investors I think for the past three years have cashed out of stock mutual funds to the tune of $300 billion. Now, mind you, this was a three-year period that saw the stock market double. So it's really more evidence of that rather tragic buy high, sell low behavior that I think mom-and-pop investors have shown for many decades.

　　And now they're realizing, many of them, that they're going to need the money for retirement. Yields on savings, on bonds are so low that they have to go out there and get some more scratch, essentially, into retirement. And it's not just retirement. It's their children's education plans. It's thrown everything into question, this great economic calamity.

　　If you thought you were retiring at 65, maybe you have to push it back to 70. Are you going to have enough disposable income? Are you going to have to downsize out of your home? And I think the Federal Reserve is still mindful of that and wants to be as accommodative as possible for as long as possible.

　　JEFFREY BROWN:Well, Joel Naroff, coming back to the signs you were seeing of potential growth, the market, other factors, address the consumer issue and the confidence issue. What signs do you see?

　　JOEL NAROFF: Well, there's actually two opposite things that's going on.

　　They're saying that they're losing confidence. The recent confidence numbers were down fairly sharply. At the same time, almost all the data that's related to consumer spending, whether it's retail sales, vehicle sales, housing market, which is really an indication of consumer confidence, are all going strongly.

　　So I think, if you look at what they're doing, not what they're saying, the consumers are still voting with their dollars that things are going to get better. Now that taxes are increased, we have got to see how they're reacting to that, but up until this point, almost everything pointed to stronger consumer spending. And that,I take as a positive sign.

　　JEFFREY BROWN:What about just filling in a little bit more on the housing sector? Because those numbers came out yesterday. They looked good. They were interpreted as very positive. But I note that even Robert Shiller himself sort of suggested that he can't read all that much into them. How important is that sector?

　　JOEL NAROFF: Yes.

　　Well, to me I think housing is critically important, not simply because of home construction, which obviously powers an awful lot of jobs. But when you consider all the people who have been underwater for so long, and they have this negative wealth effect, we have talked about the fact that 401(k)s are going up. If they see the house prices going up, they feel an awful lot better as well.

　　And so I think this strength in the housing prices are really the most important factor out there, and it's spread really across the country, not quite as strong as what's going on in some of the areas that collapsed, like Phoenix or Las Vegas. But really any price increase that we're seeing, 3 percent, 4 percent, 5 percent, in areas brings more and more people above water, they feel better, they can start making the moves they wanted to do, and that helps the economy.

　　JEFFREY BROWN:You know, Roben Farzad, we started this conversation with talk about the defense cuts hitting the GDP in the last quarter. We now face the possibility, real possibility, of more defense cuts and very big domestic cuts. That's clearly a factor in anybody's thinking for forecasting the economy going forward, I assume.

　　ROBEN FARZAD: That's true.

　　And, Jeff, frankly, I have stopped calling it the fiscal cliff. It got so tired. I'm calling it the budgetary butte, with your permission.

　　JEFFREY BROWN:OK.

　　ROBEN FARZAD: It just—it became so cliche into that final quarter of the year. And you saw the market largely shrugged it off.

　　JEFFREY BROWN:It's more picturesque. A butte is more picturesque, I think, than a cliff, but go ahead, yes.

　　ROBEN FARZAD: Yes, indeed.

　　So I feel that investors at least are not bothered about this. They see this as a game of chicken going up and down Pennsylvania between the White House and Congress. And much of this has been kicked down the road effectively for a couple of months. We do know that we have an unsustainable budget deficit situation.

　　But on the flip side of that, you have economists like Paul Krugman out there saying do not worry about the budget deficit, this is not the time to be slashing public spending. As you saw, that actually helped push that economy into decline in the final quarter. That was a big variable in that. So this is a huge debate.

　　But, on balance, what you're seeing is a lot of the unexpected has surprised to the positive. You mentioned housing. Housing is not just virtuous in that it helps homeowners and construction workers out there and material suppliers. It's also helping the banking sector, which, after all, gorged itself on these terrible mortgages back in 2007 and 2008, and it thought that it had to just write those off forever.

　　So manufacturing is surprising to the upside. Suddenly, Detroit is resurgent. Suddenly, you're reading more about people who want to set up factories here in the United States because labor is becoming more expensive in the developing world.

　　So this economy has really demonstrated an ability to surprise to the upside. And now the big question is, does this recourse back into employment? Do you see the hundreds of thousands of people who have to be hired every month to sustainably cut into this unemployment rate?

　　JEFFREY BROWN:All right, Roben Farzad and Joel Naroff, thank you both very much.

　　JOEL NAROFF: Thank you.

　　ROBEN FARZAD:Thank you.