Stephen King: Fed exposes fragility of US economic expansion

The increase in oil prices is, in itself, a relatively small negative for the American economy
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The Independent Online

"Output growth has moderated and the pace of improvement in labourmarket conditions has slowed. This softness likely owes importantly to the substantial rise in energy prices. The [US] economy nevertheless appears poised to resume a stronger pace of expansion going forward."

"Output growth has moderated and the pace of improvement in labourmarket conditions has slowed. This softness likely owes importantly to the substantial rise in energy prices. The [US] economy nevertheless appears poised to resume a stronger pace of expansion going forward."

These are brave words from a brave central bank. Last week's statement from the Federal Reserve, following its well-signalled decision to raise interest rates from 1.25 per cent to 1.5 per cent, suggests that it still believes - or, at least, wants us to believe - that the US economic recovery is very much on track. There is, however, something slightly odd about the statement, and a bit of dissection shows why. It is a mixture of fact, assertion and simple faith.

"...Output growth has moderated..." That's a fact. Following the publication of the unexpectedly soft US labour market report more than a week ago, other data have seemingly confirmed that the US economy is not quite as rosy as it once appeared. Inventories have risen quickly, pointing to involuntary stock-building. July's softer-than-expected retail sales figures were offset by upward revisions to June's, but the overall trend is no more than flat when adjusted for inflation. Exports suddenly went into freefall in June, leading to a massive increase in the US trade deficit to a new monthly record of $55.8bn, which, for those who are arithmetically inclined, implies a large downward revision to second-quarter GDP growth.

"This softness likely owes importantly to the substantial rise in energy prices." We are now moving into the world of assertion. For any country that's an energy importer, there is no doubt that higher oil prices are less than helpful. But, in real terms, oil prices are not so high - they'd have to approach $100 a barrel to provide the kind of shock that gave policymakers sleepless nights in the 1970s. So, an obvious question at this stage is why a relatively modest oil shock should apparently threaten the pace of recovery. Might it be that the Fed has doubts about the underlying foundations of this latest economic expansion, and that even modest threats to that expansion are having an uncomfortably large impact?

Seemingly not, at least from what the Fed says. "The economy nevertheless appears poised to resume a stronger pace of expansion going forward." This third strand of the statement is no more than an expression of faith, but it's been thrown into the mix partly to justify the Fed's overall desire to get short-term interest rates back to something approaching "neutrality". But if energy prices have been so important in explaining the recent softness of activity, why should it be that the economy will expand more strongly? After all, oil prices have risen further since June and July, so if oil prices are to blame, it seems more likely that the data for August and September will be weaker than we have seen over the past two months.

Perhaps the biggest problem, however, is that the recent signs of economic weakness are not confined to the US. In 2003 there were three broad areas of upside economic surprise: China boomed, Japan grew unexpectedly rapidly, and, as deflationary fears melted away the US embarked on a more sustainable, and much stronger, period of economic expansion. Recently, all three stories have headed off in the opposite direction. China's restrictions on domestic credit expansion have slowed the pace of expansion in domestic demand, with capital spending slowing from about 40 per cent annual growth to less than 20 per cent. Japan's GDP expanded at just 0.4 per cent in the second quarter of 2004, much softer than expected and, once again, capital spending was the culprit: it failed to register any increase whatsoever compared with the first quarter.

The slowdown is not unique to the US: the three key drivers of growth last year - the Pacific-rim G3 - all appear to be at least pausing for breath. But is this no more than a pause - as the Fed would have us think - or is something more serious going on?

Let's look at the oil price, first of all. The initial reaction earlier this year was to see higher energy prices as a threat to inflation. At the end of the first quarter, this looked like a credible threat: inflation did pick up uncomfortably quickly in the US. Since then, however, there has been no significant acceleration. Indeed, last week's producer price release showed an increase in core producer price inflation of just 0.1 per cent on the month. This suggests that if there's a problem with higher oil prices, it is increasingly becoming a problem for activity rather than for inflation.

Companies don't have pricing power. They would ideally want to pass on cost increases in the form of higher selling prices but are finding it difficult to do so. Instead, they are forced to take the hit on profit margins - helping to explain why so many US company outlook statements have been so downbeat - or by cutting costs elsewhere. The recent weakness of the US labour market fits in with this story.

Then there's the ability of consumers and companies to cope with this sudden loss of income. In a world in which consumers have not borrowed very much, where they are not mortgaged up to the hilt, a loss of income directly or indirectly associated with higher oil prices might not mean very much: a modest increase in borrowing might be sufficient to keep consumer spending going. In a world in which consumers have done all their borrowing, in which policymakers have persuaded them to take out unusually high amounts of debt, the willingness of consumers to get into more debt in the light of higher oil prices may be curtailed.

In fact, the increase in oil prices is but one of a number of shocks to the US consumer's well-being that may make continued economic expansion difficult. Consumers have also had to cope with rising long-term interest rates. These increases have curtailed the cash-outs or mortgage equity withdrawal that had kept consumers spending in earlier years when the labour market was not looking too bright. Consumers have also got used to a diet of tax cuts that will not be getting any bigger.

So the increase in oil prices should not be seen in isolation. The increase in oil prices is, in itself, a relatively small negative for the US economy and, indeed, for the global economy. But with China slowing, with Japan not looking quite so helpful, with mortgage rates having drifted higher, and with tax cuts no longer incrementally adding to post-tax income growth year-in, year-out, the fragilities of the US economic expansion are newly revealed.

And perhaps that's why, at the Fed's policy meeting at the end of June, a lot of attention was paid to America's external balance. In the Fed's own words, "...Outsized external deficits could not be sustained indefinitely... The adjustment, once under way, might well proceed in a relatively benign fashion... but the possibility that the adjustment could involve more wrenching changes could not be ruled out." The Fed has always known that the US has been living on borrowed time (and money). Maybe US consumers and companies have finally reached the same conclusion.

Stephen King is managing director of economics at HSBC. stephen.king@hsbcib.com

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