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Wednesday December 15, 2004 - 14:52:47 GMT

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US recession in 2005?

US Recession in 2005?

The US economy will have to adjust during 2005 as market tolerance of widening deficits has been exhausted. A combination of strong productivity growth, gradual dollar depreciation and global growth would allow the US to adjust with a period of slower growth rather than recession. The US economy is, however, not in a good position to manage external shocks, particularly with fiscal policy already stretched, and the markets may not have sufficient patience. The risks of a more rapid and forced adjustment, higher interest rates and recession during 2005 have, therefore, increased to around 30%.

US trends unsustainable

The recent economic data from the US has remained generally encouraging despite a disappointing November employment report. There has been a steady increase in consumer spending and employment with GDP growth comfortable at an annual rate of around 3.5%.

The risk of recession triggered by a substantial increase in interest rates in response to an overheated economy looks to be low. The much bigger danger to the economy comes from the underlying imbalances in the economy and by the fact that there has been no real progress in correcting these imbalances since the 2001 recession.
Overall, the US external position is no longer sustainable and there will have to be a reduction in the current account deficit. There will need to be a slowdown in spending growth with growth supported through business investment and exports. The question is whether the markets will allow this to take place gradually or whether there will be a more forced and rapid adjustment.

Debt increases risk

The level of US domestic debt will remain an important background consideration. Figures for the third quarter of 2004 recorded that personal debt had risen to 116% of disposable income. This remains a very high level in historic terms and there will be concerns over a rapid adjustment in personal balance sheets. The immediate risks have been reduced by the high level of property prices and debt is only just over 20% of household net worth. The figure will, however, become a lot more alarming if there is a significant drop in housing prices. The overall savings rate will need to increase and the high debt level increases the risk that spending growth will need to slow sharply.

There is scope for an increase in business investment, but corporate free cash flow is unlikely to be strong enough to allow a major boost.

Interest rates under scrutiny

The Federal Reserve is likely to continue the policy of gradual monetary tightening and the Fed funds rate is likely to be increased again in the first quarter of 2005 to 2.5%. There is a risk that inflation will rise more sharply than expected, especially as productivity growth has slowed and non-wage costs have been rising sharply. There is, therefore, a risk that the Fed will be forced to tighten more aggressively than expected to head off inflationary pressure, although the risk is still low.
Long-term bond yields will also be very important, especially given their pivotal influence on the housing sector. There will be concerns that any withdrawal of funds from the bond market by overseas investors will force Treasury yields up sharply. Such an increase would cause serious damage to the housing sector and would also be likely to weaken the economy sharply.

The weaker US currency should help support the export sector, but demand in Europe and Japan is unlikely to be strong enough to spur rapid US export growth.

Fiscal policy overstretched

The US administration has already expanded fiscal policy to counter an economic slowdown. With the budget deficit liable to remain over US$420bn and 3.5% of GDP this year, there is no real scope for a further relaxation of fiscal policy. If the administration does seek to boost the economy through further tax cuts or an increase in spending, there would be a high risk that long-term interest rates would increase and more than offset the stimulus. There is also the increased risk that private-sector borrowing will be crowded out.

External risks

There will be scope for overseas growth to make a positive contribution, but there will still be doubts that Euro-zone demand in particular will be strong enough to provide major support to US exports. Weak demand in Asia and Europe would increase the risk that the US will be forced into recession.

The US economy will be more vulnerable to external shocks. The US economy is like a patient with a weakened immune system as the build up in debt has reduced the ability to withstand external difficulties. Energy prices will be an important focus, although the risks have been lessened by the decline prices back towards the US$ 40 p/b level. There is a higher probability that oil prices will act as a drag on the economy, possibly cutting growth by around 0.5%, rather than causing more substantial damage.


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