by Nariman Behravesh
The performance of the U.S. economy in 2005 will be good, but not great—at least in comparison with 2004. Barring any unforeseen and sizable shocks, Global Insight predicts that the recovery will be sustained and that GDP growth will come in above the long-term trend rate of 3%. At this pace, the United States will remain the primary growth engine for the global economy.
- A Slowdown, But No Slump. In the face of higher oil prices, gradually rising interest rates, and an end to tax cuts, a "downshift" in U.S. growth is already under way. This deceleration, though, is probably not the beginning of a more dangerous downturn. To begin with, U.S. consumer spending remains resilient, thanks to an improved jobs picture, decent wage growth, and low interest rates. Moreover, capital spending has become one of the engines of the U.S. recovery, fueled by record growth in corporate profits and cash flow. Finally, with the dollar continuing to weaken and growth in the rest of the world expected to hold up, net exports will begin contributing to GDP growth, after being a drag on the economy for the better part of the last decade. Thus, Global Insight predicts that the U.S. economy will keep growing at a rate of 3.0-3.5% over the next year.
- Oil Prices Will Come Down—A Little. The surge in oil prices over the past year was driven almost entirely by strong growth in demand worldwide, especially in the United States and China. Recent slowdowns in U.S., European, and Japanese growth, combined with reduced concerns about U.S. heating oil supplies, have already brought oil prices down from their record levels of nearly $56 per barrel in late October to $40-45 per barrel in early December. With the Chinese economy expected to lose some momentum next year, oil prices are likely to remain well below their peak, averaging around $44 over the next year. As investment in oil exploration and drilling ramps up, prices will continue to slide in 2006 and beyond.
- Inflation Will Remain a Low-Level Threat. Inflationary pressures have already increased in the United States as a result of rising commodities prices, a (very) gradual tightening of labor markets, and a weakening dollar. But worries about a jump in inflation (or the more extreme concerns about stagflation) are overblown. There is significant excess capacity worldwide in both the manufacturing and service sectors. Furthermore, while U.S. productivity growth has slowed recently, it will likely remain strong by historical standards. Most importantly, much higher oil prices have not translated into a sustained increase in core inflation. As oil prices decline over the next year, Global Insight predicts that headline CPI inflation will also fall, averaging only 2.3% in 2005, compared with 2.7% this year.
- Interest Rates Will Reach 3.5% by the End of 2005. With a recovery that seems to have fairly strong legs and with inflation still somewhat muted, the Fed is on track to raise interest rates in December and five more times by the end of 2005, when the federal funds rate is expected to reach 3.5%. This gradual tightening of monetary conditions is consistent with the Fed's goal of reaching a "neutral" or "equilibrium" level of the funds rate by late next year or early 2006. Long-term interest rates will also rise gradually. Potential concerns about the size of the U.S. budget deficit and a falling dollar will be offset by a favorable inflation picture and the continuing purchases of U.S. treasury bills and bonds by Asian central banks, as they try to prevent their currencies from appreciating too much relative to the dollar. The gradual increase in interest rates will result in a manageable deceleration in both consumer spending and housing activity.
- The Eurozone and Japan Will Continue to Languish. After growing at a respectable pace earlier in the year, the French, German, and Japanese economies stumbled in the third quarter, each expanding a paltry 0.4%—one-tenth the rate of the U.S. economy! A big part of the problem has been too great a reliance on export-led growth, especially in Germany and Japan. Over the past year, roughly 80% of Germany's growth and 50% of Japan's growth were (directly and indirectly) the result of exports to the rest of the world, most notably the United States and China. As these two global growth engines have slowed, it is not surprising that Japan and the Eurozone have faltered as well. With the yen and the euro expected to appreciate next year, these economies will face stiffer headwinds. Global Insight expects both Japanese and Eurozone growth to remain stuck in the 1.5-2.0% range in 2005.
- China Will Avoid a Hard Landing. Over the past couple of years, China has become a mini-growth locomotive, especially for many emerging markets. While accounting for less than 5% of the global economy, China is credited with 15-20% of world growth. China's pull on commodity-exporting markets results from its voracious appetite for raw materials. But the Chinese engine will likely lose some steam during the coming year. In response to rising inflation, Beijing is trying to slow GDP growth (which is running above 9%) without precipitating a hard landing (defined as anything less than 6% growth). The good news is that inflation seems to have leveled off between 4% and 5%, reducing the risk of economic overheating. Moreover, the impact of a hard landing on the U.S. and other industrialized economies would be small. Any loss of exports would be offset by a fall in commodities prices, including oil.
- The U.S. Dollar Will Continue to Fall, But Won't Crash. The recent slide of the dollar reflects mounting concerns about the sustainability of the huge and growing U.S. current account deficit. This has fostered a blame game between the United States, which points to a "growth deficit" in the rest of the world as the source of the problem, and other key economic powers, which reprimand America for its "profligacy." The truth is that without policies to increase savings in the United States (e.g., through deficit reduction) and lower savings in the rest of the world (by boosting consumer spending), the burden of reducing the current account deficit will continue to fall on currency markets. Over the next year, it is a safe bet that the euro will breach $1.40 and that the dollar will buy fewer than 100 yen. However, a crash landing of the greenback seems unlikely, given that the U.S. economy is still the major locomotive of growth and that the dollar is still the principal reserve currency.
- Campaign Promises Notwithstanding, Taxes Are Set to Rise. President Bush's campaign promises to make his tax cuts permanent while cutting the deficit in half by 2009 are mutually incompatible. Chances are that financial markets (especially the currency and bond markets) will react badly to the prospects of steadily worsening budget deficits, thus forcing the administration's hand. Given that the budget gap is too big to be closed on the spending side alone, taxes will inevitably have to go up. This could happen in a number of different ways: 1) some of the Bush tax cuts could be allowed to expire; 2) the alternative minimum tax could be allowed to capture more and more taxpayers; or 3) the president could push through tax reform that would both simplify taxes and raise revenues, as the Reagan administration did in 1986.
- Offshore Outsourcing Will Persist and Possibly Accelerate. With the improvement in the job market and the end of the political campaigns, offshoring has become less of a headline issue. Nevertheless, the pressure on companies to use every possible means of cutting costs in order to maintain their competitive edge will not diminish. This means that offshoring will remain an important part of the corporate landscape in most industrialized economies. However, it is important not to exaggerate the scope of this phenomenon. Offshoring was only responsible for 2-3% of U.S. job losses during the recent downturn. Sending jobs overseas is also nothing new. It has been going on for most of the last 50 years—primarily in manufacturing. Even so, offshoring and the broader trends of globalization have not stopped the U.S. economy from generating over 70 million (net) new jobs in the last five decades, nor from improving living standards by 250%.
- Even a Major Shock Will Probably Not Derail the Recovery. The U.S. economy has proven itself remarkably resilient in the face of multiple shocks over the past few years—the bursting of the high-tech bubble, September 11, corporate scandals, and the war in Iraq. Growth momentum for the coming year is strong enough that the economy could probably withstand another big shock—a crash in the dollar, higher oil prices, or another terrorist attack—without heading back into recession. For example, Global Insight estimates that if oil prices rose to $70 per barrel, U.S. growth would only slow to around 2% next year—not good, but also not a recession. It would probably take a convergence of two or more dramatic events to push the U.S. economy into a downturn.