Caution! Trouble Ahead for the U.S. Economy

American real GDP increased 40 consecutive quarters starting in 1991-II, longer than the average trough-to-trough business expansion cycle of 28-30 quarters. The current cycle began with 2002-I, and only ten quarters have elapsed. At least two more quarters of growth are probable, most likely three. Why would expansion abort in 2005?

The Contributors to Economic Deceleration in 2005

• The U.S. invasion of Iraq has involved a series of miscalculations, and the federal budget deficit has soared midst the chaos in the Middle East. The central (federal) government deficit was US$394.84 billion, 3.7% of GDP, in the fiscal year that ended 30 September 2003 because some expenditures were postponed to the current fiscal year. The total national debt rose US$576.27 billion in that year, partially explained by the deficit being reported with trust fund surpluses. The forecast is for a shortfall of 4.3% of GDP, but spending in Iraq has increased since that projection.
• Economic recovery has caused a surge in global demand for crude oil and natural gas. In addition, the U.S. government added to the Strategy Petroleum Reserve during 2003 and has subsequently refused to release supplies to counter the spike in gasoline and other petroleum product prices. In May crude oil prices surpassed US$40 per barrel, and OPEC postponed a decision on Saudi Arabia’s plan to raise quotas and increase output.
• Washington, D.C., is financing budget deficits with feverish sales of Treasury bills, notes, and securities. Other levels of government have experienced a series of federal security laws and regulations that are unfunded and have greatly increased the need for revenue through bonds, loans, and taxes. Parallel to this, business has begun to invest in administrative, production, and research systems that increase company productivity and product innovation. Briefly, demand for credit has greatly increased in 2004.
• The US$ depreciated in 2003 and part of 2004. The U.S. had a current account deficit of US$541.83 billion in 2003 and American companies invested US$154.76 billion in foreign operations (net outflow of US$72.77 billion after foreign direct investment in the U.S.). This was an enormous amount of US$s transferred abroad. Until the advent of the weak US$ and the rise in interest rates, foreign investors returned those US$s to portfolio securities in American financial markets (92.8% debt securities in 2003). However, with the capital risk (when interest rates rise, the value of debt securities declines) and currency risk, a serious imbalance is developing.

The Perpetrators Causing Deceleration

• The borrow-and-buy, installment-dependent American consumers owed US$2035.37 billion at the close of 2003, or US$17,763 per household. Residential mortgage debt was US$7994 billion at the time, or US$69,767 per household. Most of the consumer loans and some of the mortgages will be affected by higher interest rates. Because household expenditures were 70.3% of GDP in 2003, purchasing capacity will decline. How much depends on the slope of the upward trend in interest rates, but it is certain that the cost of money will outpace gains in household income.
• Consumer price inflation in April 2004 was 2.2% more than in April 2003 (2.3% average last year). The impact of petroleum prices increases will be magnified during the remainder of year by the U.S. Energy Department’s statement that imported crude oil must average 10.4 million b/d throughout the American summer to avoid depleting refiners already low inventories. This level has been sustained only for five weeks in the past. Supply is further complicated by foreign producers not being able ship the crude oil required under new regulations in Connecticut, New York, and California.
• Excluding inflation, the momentum behind increases in interest rates would be limited by the FED, which recognizes that any increase in the cost of money will add to the budget deficit. In FY2003 the federal government paid US$318.15 billion in interest to holders of the national debt, compared to US$332.54 billion the previous year because of low yields on debt securities. The 10-year bond was 4.78% on 19 May 2004, compared to a low point of 3.33% in July 2003. This trend will continue.
• The prime rate is currently 4.0%. Sixty-month new car loans averaged 5.49% in mid-May, nearly unchanged in the past year. It is predicted that the prime rate will reach 5.25% in the first quarter of 2005 and that the spread between the prime and other retail rates will increase because of concern about consumer credit-worthiness. Therefore, the rate for sixty-month new car loans will be about 7.0%, excluding sales incentives offered by manufacturers.

Estimating the Degree of Deceleration

• In the past the factors cited above have usually caused three consecutive quarters of decreased real GDP, more than enough to be deemed a recession. Increases in interest rates by the FED (in addition to those stemming from market forces) are intended to decrease demand-pull price pressures and offset such cost-push factors as crude oil prices. The more that interest rates rise, the greater the loss in purchasing power for consumer items, homes, and services because installment payments on existing goods and services are rising faster than income. (The obvious exception is loan contracts involving fixed rates.)
• The FED will make one increase in interest rates before the November elections and another shortly afterward. Only a doubling of the consumer price rate to ±4.5% for 2-3 months in a row will cause three increases in 2004. In early 2005 one quarter of decreased real GDP will occur, and unemployment will rise 0.2%. At this stage much depends on business and consumer sentiment. Without confidence that economic recovery will regain momentum, another quarter of decline could occur. In mid 2004 this is not predicted. Only another major shock (a large-scale, successful terrorist attack, a sharp upturn in loss of American lives in the Middle East, etc.) could kill growth and cause a recession.