FEBRUARY 2005

Too Much Domestic Economic Strength?

The latest economic data paint a rosy picture of the ongoing U.S. economic expansion. The picture is, perhaps, too rosy given the mushrooming trade deficit and all the talk in Washington about expensive solutions for both foreign and domestic problems (e.g. Iraq and Social Security reform).

First, let's look at the latest numbers. Real Gross Domestic Product (adjusted for inflation) grew 4.4 percent in 2004, the highest growth rate since 1999. Real GDP grew by 3.1 percent in the fourth quarter, slower than the 4.0 percent rate of the third quarter. The slowdown was primarily due to a slowdown in consumer spending (4.6% as opposed to 5.1% in the third quarter) and a rising trade deficit (exports fell as imports rose). The U.S. unemployment rate fell in January 2005 to 5.2 percent, down from a peak of 6.4 percent in June 2004. Strong job growth indicates that consumer spending will also remain strong over the remainder of the year, continuing to bolster demand for imports. The dollar has fallen relative to many foreign currencies, but thus far not fast enough to cause stronger growth in export demand than in import demand. Hence, the continued rise in the trade deficit.

Many economists both in the U.S. and abroad have expressed ongoing concern that the U.S. trade deficit continues to balloon. In the economic newsletter, The Pocket Chartroom, Goldman Sachs economist Jan Hatzius says "The key issue in the U.S. economic outlook is how the economy will unwind its current account deficit in the coming years." Hatzius says that two alternatives are possible. In the first scenario, domestic spending slows and stays sluggish for several years, holding down import growth and allowing interest rates to remain relatively low. The alternative scenario, more likely in his view, is that exports pick up due to a depreciating dollar, boosting U.S. income growth, creating upward pressure on prices, and triggering upward pressure on interest rates. Indeed, the latter scenario seems to be unfolding.

In recent speeches Federal Reserve Board Chairman Alan Greenspan has signaled his expectation that the falling dollar will finally begin to improve the trade deficit this year. Greenspan suggested that the tendency of foreign companies in recent years, especially European companies to keep their prices low in an aggressive pursuit of market share will now give way to an emphasis on rising prices to shore up profit margins. This should help curb U.S. imports of foreign goods, at the same time giving U.S. companies an opportunity to expand their market share overseas.

All of this suggests that 2005 should be a year characterized by strong domestic growth, continued job growth and declining unemployment, upward pressure on wages and prices, and a slow but steady rise in interest rates. The trick facing policymakers will be to control the upward pressure on prices and interest rates, given stronger domestic economic growth and the competing demands of big appropriations for federal spending programs.