Can America keep it up?

Dec 14th 2005
From The Economist Global Agenda

As the Federal Reserve raises interest rates again and the trade deficit breaks another record, the American economy continues to confound the sceptics. Thanks for that go largely to resilient consumers and booming productivity

FOR several years now, economists have been watching American consumers with the same mixture of astonishment and anticipation that wide-eyed fans bring to endurance sports: amazing that they’ve made it so far, but how much longer can they go on like this? Strong consumer spending has underpinned America’s robust economic expansion, even as most other industrialised countries have struggled to get their economies back on track. But consumers have been running down savings to sustain this level of spending; the personal savings rate has actually been negative since June. Booming house prices and low interest rates have enabled consumers to take on more debt without suffering much, but with interest rates now climbing, Americans have begun to feel the pinch. Data from the Federal Reserve show that the percentage of household disposable income devoted to servicing debt was a record 16.6% in the third quarter.

Yet the consumers soldier on. Figures released by the Census Bureau on Tuesday December 13th show that retail sales in November, when the Christmas shopping season starts, were up by 0.3% from October, and 6.3% higher than a year earlier. And on Wednesday, the Department of Commerce announced that imports of oil, cars and consumer goods caused the already gaping trade deficit to balloon even further in October, to a record $68.9 billion (see chart). This surprised economists, who had been expecting the deficit to fall slightly as oil prices subsided from their September highs.

It seems unlikely that consumers will have the stamina to keep this up much longer. While petrol prices have fallen back, crude oil is still trading above $60 a barrel, pinching the pockets of fuel-guzzling Americans. Long-term interest rates are currently kept low by foreign central banks buying dollars—and dollar-denominated assets—to keep their currencies cheap. But those mountains of dollars are creating ever bigger problems for the banks, which may have to cut back soon. That would bring on a sharp increase in American interest rates, which in turn would deflate the housing bubble—if it doesn’t shrivel on its own first. There is growing evidence that this may be happening already.

Economists have long been warning of these risks. But someone plainly forgot to tell the economy that it was supposed to be in trouble. According to figures released earlier this month, GDP grew at an annualised rate of 4.3% in the third quarter, revised upward from a preliminary estimate of 3.8% issued in November. That is despite the ravages wrought by hurricanes in August and September, which not only destroyed a major port city but closed down a big chunk of the energy industry.

Better still, last week the Department of Labour reported that over the same period, productivity had grown by 4.7%. And payrolls, which barely grew at all in September and October, finally posted a respectable 215,000 new jobs in November. Little surprise, then, that George Bush is once again talking up the economic data, and seeking to claim some of the credit for his policies, particularly tax cuts.

Sadly for Mr Bush, it appears someone also forgot to tell the voters that the economy is doing well. Polls show approval ratings for the economy on a par with the rest of his dismal numbers. Employment has generally lagged behind the economy. Payroll employment troughed in May 2003, 18 months after the recession ended. Since then, the economy has added 4.5m jobs—and unemployment currently hovers around 5%. But wage growth has been sluggish, implying a soft jobs market.

The economy is also posing some difficult questions for the Fed, whose monetary-policy committee met on Tuesday. The central bank has steadily raised short-term interest rates over the past year and a half to fight off inflation. But where does it want to stop? As expected, the Tuesday meeting delivered another 25 basis-point increase in the benchmark interest rate, to 4.25%, but the language of the accompanying statement contained both hawkish and dovish signals. Unlike previous statements, there was no mention of “accommodation”, suggesting that the Fed considers monetary policy to be close to neutral, and will stop tightening soon. But strong wording also indicated that at least one or two more rate increases can be expected before the cycle turns. Nonetheless, the dollar dropped on the news, a decline that grew steeper after Wednesday’s trade figures.

High oil prices may not have translated into slower economic growth yet, but they are creating inflation, which ran well above 4% in September and October. On the other hand, core inflation, which excludes volatile energy and food prices, is still relatively modest. With gasoline dropping back to $2.19 a gallon from nearly $3 in September, fears that high oil prices will feed through into the broader price index have eased. And the stellar productivity figures increase the pace at which the economy can grow without fuelling inflation.

Ben Bernanke, the incoming Fed chairman, will want to be tough, to prove to financial markets that he is serious about keeping prices stable. But if current trends continue, he will not have to be so tough that he causes serious economic pain. Those economists may continue to be astonished for quite some time.

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