PROSPECTS 2005: Quiescent inflation allows US growth

Analysis

Recent recessions have been so brief (averaging seven months for the 1990 and 2001 recessions) that observers assume the economy has a strong propensity for growth.

During the 22 years since the business cycle trough of November 1982, the economy has been in recession only 14 months or a mere 5% of the time. During the period 1945-82, the economy was in recession 22% of the time. Recessions were more common before the 1980s because rising inflation forced the Federal Reserve to hike interest rates in order to restore price stability. Since the 1980s, the economy has enjoyed a prolonged period of low inflation or disinflation which has lessened the pressure on the Fed to play an actively restrictive role.

Cyclical stability. There is a general consensus on Wall Street that the economy will enjoy 3.5-4.0% growth during 2005 compared to about 4.3% this year, largely because inflationary threats are seen as well contained:

• The Blue Chip survey of 50 forecasters is projecting output growth of 3.5% during 2005 and an inflation rate of 2.4% compared to 4.4% output growth this year and an inflation rate of 2.6%. The forecasters also expect corporate profits to rise by 10.5% next year compared to a gain of 15.7% this year.
• The Business Roundtable CEO confidence index was at 98.9 in early December compared to a previous peak of 101.7 in September and 67.7 during October 2003.

Analysts are optimistic because they believe inflation will average only about 2.4% next year compared to 2.7% this year. If inflation remains subdued, the Fed will be able to continue its policy of incremental tightening rather than risking a highly restrictive policy. The core PCE inflation rate index in the twelve months through October was 1.5% compared to 1.1% at the end of 2003. There is little doubt that inflation has begun to accelerate but the rate of gain is still very modest. There is evidence that productivity growth has begun to decline -- if this trend persists, it will increase the risk of either a contraction of profit margins or higher inflation (see UNITED STATES: Odds rise for 'stagflation' scenario - September 1, 2004).

Structural questions. Uncertainties centre instead on structural imbalances. The personal savings rate has dropped to an unprecedented low of 0.2% because the household sector has been enjoying steady gains in house prices during the past five years and an upturn in the equity markets since 2002. Households also have significantly expanded their use of mortgage debt to finance consumption. Since the end of the recession in 2001, over 90% of the increase in total household debt is due to the growth of mortgage borrowing, which has increased by 25% after adjusting for inflation. In contrast, consumer credit (eg credit cards and automobile loans) has increased by only 4% over the same period. Mortgage debt has grown from 32% of GDP in 1980 to 60% today (and consumer credit from 13% to 18%). Yet while debt has increased, household assets have increased to nearly 50 trillion dollars or a level five times as large as total GDP. House prices rose 13% during the third quarter, the largest gain in more than 25 years.

Low personal savings and a federal fiscal deficit close to 4.0% of GDP have driven the current account deficit to 6.0% of GDP, and it could expand to 7.0% during 2005. Because the federal deficit looks unlikely to fall sharply during the next few years, the current account deficit has become a central concern for markets, fuelling dollar weakness. The Bush administration has been relaxed about the dollar's decline because it has not yet produced a large increase in US bond yields. If the bond market finally experiences a major correction which drives up mortgage rates, the administration could change the tone of its comments. However, short of reducing the federal deficit, there is little it can do other than acquiesce in trading partners' reserve accumulations -- which it has largely done to the present (see UNITED STATES: Sanguine response to Asian fx policy - February 19, 2004; and see INTERNATIONAL: G20 pressed to address currency fears - November 18, 2004).

Policy agenda. The Bush administration plans to introduce proposals for social security privatisation, tort reform and tax reform during 2005. The major concern in the financial markets about social security privatisation is that it could add 100 billion dollars or more to the federal deficit. Business supports tort reform because it is estimated that the current tort rules cost US firms about 250 billion dollars per annum. The administration may create a commission to introduce new tax reform proposals. They are likely to focus on eliminating the alternative minimum tax, further reducing taxation of capital, and perhaps introducing a national consumption tax in order to lessen the role of the income tax. It is doubtful that the tax reform proposals will come in time to influence the economy during 2005 but they could be important in later years. The social security reforms could boost long interest rates if they set the stage for a major expansion of the fiscal deficit.

The markets will become increasingly concerned during 2005 about the pending retirement of Federal Reserve Chairman Alan Greenspan. The financial media has focused on several possible replacements, including Professor Martin Feldstein of Harvard University, Professor Glen Hubbard of Columbia University, John Taylor of the US Treasury, and Roger Ferguson, the current Fed vice chairman. It is doubtful that the administration will make a decision before the fourth quarter of 2005. Because market volatility has increased in the past after the appointment of a new Fed chairman, investors will be watching the issue closely. The greatest risk would be the administration turning to an unknown business leader, such as happened with the appointment of G. William Miller in 1977. It would take such a candidate several months to establish credibility in the markets and win the confidence of investors.

Expenditure sources. Capital spending will need to be a growth locomotive during 2005. US firms have experienced a significant recovery in profitability and have balance sheets with high levels of liquidity. Most econometric models suggest that capital spending has increased by far less since 2002 than traditional cyclical factors would have warranted. Greenspan attributes this weakness to corporate concern about the regulatory climate and policy changes such as Sarbanes-Oxley. While concerns about Sarbanes-Oxley have not gone, they are waning, in which case investment should accelerate during 2005, assuming Greenspan's hypothesis is correct. There should also be a stronger contribution from net exports, which itself would encourage corporate spending (see UNITED STATES: GDP results hint at export boom - August 3, 2004).