Smith Faculty Opinion Article - October 10, 2005

The U.S. Economic Outlook
By Dr. Peter Morici, Professor of International Business

Since spring 2003, the U.S. economy has enjoyed rather substantial economic growth; however in recent months, the consensus of economists has anticipated slower growth the first half of 2006. The outlook is clouded by four sets of demand side developments: rising oil prices and related energy prices; Federal Reserve interest rate increases; Hurricanes Katrina and Rita; and the nexus of issues surrounding the trade deficit and overvaluation of the U.S. dollar against Asian currencies, in particular the Chinese yuan.

At the outset, it is important to recognize that the supply side potential of the U.S. economy remains strong. The economy has the potential to grow at a 4.5 percent rate through the end of 2007. With all cylinders hitting, productivity growth in the 3 percent range and employment gains of 1.5 percent are easily attainable without setting off either wage inflation or widespread shortages of industrial capacity. Unemployment remains a percentage point above 2000 lows and labor force participation rates, especially among prime working age adults, remain low too.

Weakness on the demand side will keep the economy from accomplishing this potential by some considerable amount.

The current recovery has enjoyed substantial lift from consumption spending and a housing construction boom. These have been financed, in the face of modest wage increases and increasing local taxes and health care costs, by rising home equity values, low mortgage rates and ever more creative financing schemes such as zero down, and zero principal and partial interest payment ruses. These channels now appear exhausted, as household spending now exceeds disposable income, the appreciation of housing values seems to be abating in key markets for example in Manhattan residential values fell in the third quarter and banks have run out of options other than forgiving principal and interest payments altogether. Since it is unlikely regulators will permit banks to give money away, the housing gravy train is due to slow.

Even before Katrina, crude oil prices had more than doubled from September 2003, and higher gasoline, natural gas and heating oil prices were dragging on consumer spending in other areas. While some of the revenue from higher fuel prices gets recirculated through industry profits and spending, much leaves the country and swells the trade deficit, which drags on demand and GDP growth.

The run up in gasoline prices, even without Katrina, would have reached $2.80 or $2.90 a gallon and the consequences for General Motors and Ford were already painfully apparent. Going forward, these companies are destined to sell off assets for example, GMs sale of its interest in Subaru and Hertz by Ford and if the recent labor settlements in Canada are any indication of how things will go here with the UAW, it is only a matter of time before losses and legacy costs overwhelm the balance sheets of these companies. Asian investments in North American automobile production, by any reasonable stretch, will not wholly compensate for the damage the contraction of GM and Ford imposes on U.S. auto suppliers and vehicle production.

Global commodity prices have been pushed up by rapid growth in China and elsewhere in Asia and by tight oil refining capacity worldwide, pushing up commodity prices in the United States. Although inflation has been higher in 2005, core inflation less food and energy has been cooling. Nevertheless, the Fed is bent on raising interest rates to reduce inflation, even though it is caused by factors outside the domestic economy and largely beyond the reach of Fed policy.

To date, Fed interest rate increases have not had a large effect on mortgage and other long-term rates, because Asian foreign central banks are purchasing so many dollars to keep their currencies from rising and Middle East oil producers are recycling a good deal of their newly-found wealth into savings in U.S. assets rather than spending it as they have in the past.

There are limits to how much longer long rates can be suppressed, and the Fed, concerned that the housing boom is a housing bubble, seems intent on pushing up the Federal Funds rate until it affects long rates and curbs housing prices nationally. Hence, along with the boom in consumer spending, growth in residential construction may be expected to quell as we move through the next twelve months. Some moderation would be healthy; however, a real risk is that the Fed will raise rates too far and send the housing market, consumer spending and the economy into a tailspin.

Normally, hurricanes and similar disasters reduce growth for a quarter or two and then give growth a lift as rebuilding replaces lost growth after one or two quarters. However, the combination of Katrina and Rita is no ordinary disaster the scope and reach of dislocations are unprecedented. Some industries and communities will not be rebuilt to their former scale, and the region will likely lose skilled workers who do not return. The costs of using Gulf ports and resources processed in the area will likely remain higher for many months to come, regardless of what interest rate policy the Fed pursues. Perhaps, half of the lost growth will be recovered.

Finally, the trade deficit continues to drag on U.S. growth, both by lowering demand in the present and reducing the long-term potential of the U.S. economy.

The monthly trade deficit has increased from $29.8 billion in January 2002 to $57.9 billion in July 2005, and petroleum accounts for only about $12.3 billion of this increase. The balance has been caused, in considerable measure, by an overvalued dollar against Asian currencies, and in particular the Chinese yuan. This creates a substantial drag on growth, and realigning currency exchange rates with Pacific trading partners generally, and China in particular, to substantially reduce the trade deficit, say by fifty percent over three years, would do much to assure the economy realizes its longer-term growth potential.

Balancing all these factors (Katrina and others) together I have adjusted my GDP forecasts as follows

The risks I see are to the downside. If the Fed hits the break too hard by not knowing when to stop raising interest rates or events further disrupt refined petroleum and natural gas supplies, the outlook for 2006 could become considerably worse. Relationships between Fed policy and energy prices, on the one hand, and consumer and business behavior, on the other, are not linear as most econometric models assume. Overreaction to transitory inflationary pressures or another major gasoline price spike could easily cause a sea change in the economic outlook and even plunge the economy into a recession.