Thursday, July 21, 2005

U.S. Economy Continues To Expand--For Now -

An easy to read article from Forbes magazine talking about the state of the economy, economic indicators and other important economic data.

Oxford Analytica
U.S. Economy Continues To Expand--For Now
Oxford Analytica, 07.15.05, 6:00 AM ET

The U.S. economy enjoyed its eighth consecutive quarter of expansion above 3% from April to June 2005, the longest period of such robust growth in two decades. Indeed, growth in the second quarter was revised upwards this month from 3.1% to 3.8%, indicating that the economy is more resilient than was earlier anticipated. At least in the short term, the economy will continue its robust expansion.

In early 2005, it was widely perceived that the massive U.S. trade deficit would encourage a further major dollar devaluation this year in order to set the stage for current account improvement. However, the currency had rallied by nearly 10% against the euro and also enjoyed gains against the yen and other currencies.

The dollar's appreciation indicates that the current account deficit could expand to $900 billion during 2006. While the dollar's rally demonstrates that global financial markets are more capable of sustaining large payment imbalances than most economists would have imagined possible only five years ago, concerns about the currency will eventually re-emerge.

According to the latest Congressional Budget Office forecasts, the strength of the economy will help reduce the federal budget deficit to $325 billion in fiscal 2005. However, the current account deficit will remain large because the household savings rate is still less than 1%, and the corporate savings rate will decline as capital spending increases. The critical factor determining demand for the dollar will probably be the performance of the economy. If steady growth can be sustained with stable inflation, there will be sufficient demand for U.S. financial assets to fund an expanding current account deficit. However, if monetary tightening tips the economy into a downturn, confidence will erode and the dollar could suddenly plunge.

The economic outlook thus centers on two main issues. Firstly, in terms of the monetary policy outlook, it is likely that the Fed will increase short-term interest rates to at least 3.5% by August. However, the fact that yields on ten year Treasury bonds are still only about 4.1% demonstrates that many investors are quite complacent about monetary policy. Bond market bulls believe the economy will lose momentum during the next few months and force the Fed to halt tightening. They point to the sharp slowing of personal income growth during May and the recent weakness of durable goods orders as evidence of faltering growth. They also interpret the flattening of the yield curve as a sign that policy has become restrictive and growth will soon slow.

However, the economy does have considerable underlying strength. On the basis of new government data, wage and salary income is now growing at a 7.5% annual rate. Such rates are likely to sustain consumption, despite the low savings rate in the household sector. The resilience of profits, coupled with strong corporate balance sheets, points to further steady gains in business investment.

The Fed is likely to continue increasing interest rates, because it perceives that the economy enjoys solid growth momentum and that the risk of inflation is increasing. The core Personal Consumption Expenditure (the average measurement of consumer prices minus food and energy) deflator is now 1.6% above its level one year ago, while broader measures of inflation have risen into the 2% to 3% range because of high oil prices. The government's new income data also indicates that wage growth is accelerating at a time when productivity growth is eroding. The Fed is comfortable with an inflation rate of 1% to 2%, but will not perceive monetary policy with such an inflation rate as neutral until the funds rate increases to 4%.

Secondly, in terms of the housing market outlook, the sharp rise in sales and home prices has pushed the value of real estate transactions up to $160 billion per month, compared to $340 billion per month for retail sales. Housing transactions are thus equal to half the value of retail sales compared to only one quarter in 1995. The ownership of housing is also much broader than the ownership of assets such as equities. The government's data on consumer wealth indicates that the top 1% of households own one-third of the value of all equity, while they own only one-eighth of the value of housing. The concern about housing reflects evidence of increasing speculation in the market.

The key factor likely to dampen the housing market is rising interest rates. Despite a year of monetary tightening, mortgage rates have not increased because ten year Treasury bond yields are still close to 4%. If bond yields rise into the 5% to 6% range, the cost of mortgages will increase and dampen housing demand. However, rising short-term interest rates will not threaten the housing market without rising bond yields.

Providing that core inflation remains below 2%, the Fed's goal is to fine-tune a soft landing to a Gross Domestic Product growth rate close to 3%. However, it cannot control the level of bond yields that are now so critical to the housing market. If the bond market experiences a major correction, housing will cease to be a growth locomotive, and the growth rate of consumer spending could slow sharply. The outlook will thus depend heavily upon how bond investors, not just the Fed, perceive the economy's tradeoffs between growth and inflation.

U.S. Economy Continues To Expand--For Now -
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