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Is America Poised For Growth?

July, 2003

Perhaps, but don't expect anything like a boom.

Is America's economy finally set to shake off its funk? An increasing number of economists on Wall Street and politicians in Washington seem to think so. Many number-crunchers are forecasting a sharp acceleration of economic growth in the summer. John Snow, America's treasury secretary, suggested this week that the economy could be growing by around 4% by the end of 2003, more than double its current rate. After so many false dawns, is this optimism justified?

Financial markets certainly think so. All the big stockmarket indices have risen dramatically. The Dow Jones Industrial Average is now over 9,000, up more than 20% since mid-March; the technology-laden NASDAQ is up almost 30% from three months ago. Financial conditions have loosened across the board. Not only are government bond yields at historic lows, but spreads on corporate bonds have narrowed sharply, making access to capital cheaper and easier for firms of all kinds. A weaker dollar-the greenback has dropped by 8% against the currencies of America's trading partners this year-has also added to the loose financial conditions.

And there is more to come. Judging by recent comments from its top official, America's central bank is highly likely to cut interest rates when its policy-setting Federal Open Market Committee meets on June 24th-25th. Alan Greenspan and other central bankers have become increasingly concerned about the risk of deflation, and are determined to ward it off. With America's economy still swimming in spare capacity, the rate of inflation continues to decline. Core consumer prices-that is, excluding volatile categories such as food and fuel-were flat in both March and April, after several months of small increases. As economists at Goldman Sachs point out, that brings the annualised rate of core consumer-price inflation over the past six months to below 1%, the lowest rate in almost four decades.

Although Mr Greenspan reckons that the likelihood of "corrosive" deflation in America is low, he intends to "lean over backwards" to avoid it. That means cutting short-term rates, and keeping them low. Judging by the prices of futures contracts, investors now expect a quarter-point rate cut with certainty on June 24th, and see a 50% chance that short-term rates will be cut by half a percentage point.

Nor is looser monetary policy the only stimulus on the way. Mr Bush's latest tax package, signed into law on May 28th, will undoubtedly give the economy a short-term boost. The huge tax package-worth $350 billion over ten years if you believe Congress's gimmicks, and costing more than $800 billion over a decade if you take a more realistic view-may not be particularly efficient as a stimulus package. But it is big. Economists at Morgan Stanley reckon the tax cut will add about $160 billion, or 1.5% of GDP, in fiscal stimulus over the next four quarters, bigger than any tax change since the Reagan tax cut in 1981. Of that, around $64 billion will reach Americans quickly in the form of rebate cheques and less tax withheld from their pay. Even if a large chunk of this is negated by tax hikes and spending cuts at the state level, the net effect will still be a sizeable stimulus-and an increase in the budget deficit. The Congressional Budget Office this week raised its deficit forecast for fiscal 2003, which ends in September, to over $400 billion, or around 4% of GDP.

Add together loose financial conditions and a fiscal boost, and it is hard to imagine that the economy will not improve at all. Lower financing costs are continuing to prop up the housing market and maintain the surge in mortgage refinancings. The weekly tally of mortgage refinancing applications reached a new high of nearly 10,000 last week.

Even in the gloomy labour market, there are glimmers of hope. True, America's jobless rate hit a cyclical peak of 6.1% in May, and weekly unemployment claims are still extremely high. But the employment report released on June 6th was in many ways less bad than expected. Although the economy lost 17,000 jobs in May, the number of private-sector jobs was flat; the drop came in government posts. The number of temporary jobs rose by a healthy 58,000, and a rise in temporary workers is often a sign that firms are thinking of hiring permanent workers again. The latest monthly survey of purchasing managers also suggests that conditions in both the manufacturing and services sector are already improving, although they are far from booming.

A trickier question is whether any rebound will last. Can America's economy expect above-trend growth next year, for instance? There, it is much harder to be optimistic. America's economy still has huge fragilities. Although firms have undergone great adjustments since the excesses of the stockmarket bubble, there is still plenty of spare capacity around, making a sustained investment boom less likely.
More troubling is how long America's consumers can continue to fuel the economy. Levels of consumer debt are rising sharply, driven largely by the refinancing boom. According to Jan Hatzius, an economist at Goldman Sachs, household debt is growing at a 10.3% annual rate, more than twice the trend growth rate of disposable income. The ratio of household debt to disposable income is at an all-time high but, with interest rates falling, the ratio of consumers' debt-service bills to their income is below its historical peak.

Clearly, the rate of consumer debt accumulation cannot be sustained. At some point, it will have to slow, which means lower consumer spending. Falling interest rates and tax cuts will put off the day of reckoning, but not for ever. That, more than anything, is why the recovery may be less robust than the optimists expect.

Courtesy of: http://www.economist.com