September 13, 2002
U.S. Economy"Yes Virginia, there was a recession last year." The August estimate of the National Income and Product Accounts by the Department of Commerce shows three quarters of negative growth, when in their July estimates they showed only one quarter. See the figures below:
2001 |
2002 |
|||||
Real GDP growth |
I |
II |
III |
IV |
I |
II |
July Estimate |
1.3 |
0.3 |
-1.3 |
1.7 |
6.1 |
NA |
August Estimate |
-0.6 |
-1.6 |
-0.3 |
2.7 |
5.0 |
1.1 |
We still expect the economy to show a zig-zag pattern of high and low growth with a possibility that the economy could show a negative quarter. The recovery will be very uneven. We think consumer spending has held up relatively well despite the devastating impact of September 11. While consumer sentiment has been slipping recently, spending could still manage to pull ahead. At the same time, business investment is not yet ready to take off, which could further dampen the strength of the recovery. Business investment in machinery and equipment did post a moderate growth of 2.9 percent in the second quarter.
In terms of output of goods and services, manufacturing and construction are still weak. The services economy has demonstrated greater resilience, specially the small business sector, which is less vulnerable than large corporations to the hazards of high overhead during lean times.
Inflation appears to be stable with our measure of the trend rate at 1.7 percent in July, which is about the same as what we expect for the average rate this year. We still see inflation moving to the 2.5 - 3.0 percent range in 2003.
The combination of weak growth and still moderate inflation argue in favor of the Fed holding the line on rates at its September 24 FOMC meeting. In fact, Fed Funds December futures contracts are trading at a rate of 1.63 percent, implying that the market still expects the Funds rate to move down. However, we do not anticipate further reductions in the key monetary policy rate, instead we think the Fed will hold the rate at the current 1.75 percent level.
Nevertheless, we think the economy is facing significant risks once again from the twin deficits, that are being supported by an expansionary monetary policy (see out StratAlert for August 15, 2002), and which could push rates higher. First, as we have been warning for some time, the dollar is on the edge of a steep downward slope. We continue to predict that the U.S. trade deficit will reach an unsustainable 5.0 percent of GDP this year. For example, during the second quarter, real exports of goods expanded by 16.4 percent, but imports surged by 28.5 percent. We think there is a possibility of a sizeable drop in the value of the dollar in the short-term as foreign investors begin to acknowledge that the U.S. has a major trade deficit problem. The last time the dollar took a beating was during 1985-1987; and perhaps we could see a similar decline. During the 1970s, the dollar had also gone through a protracted downtrend following the breakdown of the Bretton Woods monetary system in 1973.
Second, the fiscal accounts are starting to post sizeable deficits. Not long ago, lawmakers were chanting a tune of fiscal exuberance, with intense discussions on how to spend the 2010 surplus. Hopefully, a lesson in fiscal prudence has been learned, mainly, focus debate on the fiscal accounts for the next two to three years, and leave any discussions of long-term budget forecasts to policy planners. In its August projections, the Congressional Budget Office expects the On-budget deficit to average about 3.0 percent of GDP during 2002-2004, and the budget is expected to remain in the red during the forecast period 2002-2010.
Both deficits are feeding from a strong expansion in domestic liquidity caused by the Fed’s actions to lower the Fed Funds rate starting in January 2001. As we have mentioned in previous StratAlerts, the excess growth in domestic liquidity has not yet been reflected in higher demand-induced inflationary pressures; instead, it has triggered a surge in imports, and thus to unsustainably large trade deficits. At the same time, the influx of imported goods has been limiting the extent of the recovery in the manufacturing sector, since consumers are spending the increased liquidity on imported goods and services made more attractive by the strong value of the dollar.
Another risk to the outlook deals with the potential for military conflict in Iraq, which could result in significant increases in oil prices and consequently higher inflation rates, and thus prompt the Fed to raise interest rates.
Latin American Economies
All eyes are on Brazil’s presidential elections. While Lula maintains its lead, official candidate Jose Serra has overtaken Ciro Gomes and is now on a virtual tie with him on second place (for additional information on recent trends, see our Special Alert on Brazil).In Colombia, president Alvaro Uribe warns of difficult times ahead for the nation, as a result of the war effort.
Official estimates indicate that Dominican Republic’s economy grew by 6.0 percent in the first semester of this year, despite weakening free zone activity.
A prolonged drought in Central America is adding to the difficulties resulting from the coffee crisis. In Guatemala and Honduras large crops of food staples such as beans and corn have been destroyed for lack of rains.
Slow recovery in the Mexican economy. Gradual upturn in manufacturing. Weak demand and strong family remittances have contributed to a reduction of the current account deficit in the first semester.