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Thursday September 22, 2005 - 14:56:55 GMT

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Running on empty - US growth under threat

External shocks such as hurricanes Katrina and Rita would not normally disrupt longer-term economic trends. There are, however, likely to be major concerns over spending levels this time, especially with the US consumer already over-stretched. The US is also running substantial current account and budget deficits and there will be upward pressures on both deficits over the next few months. Overall, the economy is not in a good position to manage external shocks, especially with a very low internal savings rate.

The Federal Reserve will need to monitor inflation levels closely due to the impact of high energy prices and will also have to steer policy very carefully over the next few months as mistakes could prove costly. Given the net risks, it is likely to be more difficult to maintain overseas confidence in the US economy, especially given the underlying trade deficit fears.

The US economy has proved extremely resilient over the past few years and could certainly power ahead again. Overall, however, there is a considerable risk that the twin-hurricane threat will help trigger an important tipping point for the US economy which results in a sharp slowdown in growth over the next year.

Second hurricane threat

US confidence levels will remain an important focus in the short term, particularly with the US again under threat from another hurricane. Rita has developed from a tropical storm and is now officially a category 5 hurricane.

Hurricane Katrina has certainly had a short-term impact. Consumer confidence weakened sharply in the latest University of Michigan survey with a slump to a 13-year low in the early September reading. There was also a sharp drop in the Philadelphia Fed manufacturing index survey for September.

Weather events such as hurricanes Katrina and Rita would not normally have a long-term impact on the US economy with optimism that confidence levels would recover quickly over the next few weeks. There are, however, reasons to be concerned over underlying US trends and there is a greater risk that the hurricanes will prove to be a significant watershed for the US economy. The risks will inevitably be magnified if there is serious damage from Rita over the next few days.

Vulnerable to external shocks

The principal concerns are likely to surround the fact that the US consumer sector is not well placed to managed to external shocks. The latest personal spending data recorded that the US was running a negative savings rate, the lowest rate for at least 60 years. If there are any downward pressures on income levels, there will quickly be pressure for spending levels to be cut as there will be little cushion from lowering savings rates.

Similarly, US consumers will fell a significant impact from high energy prices and rising essential costs, especially as prices have increased strongly for 2005 as a whole. US retailers have been successful in pushing sales over the past few months, but there is a high risk that there will now be a sharp slowdown in consumer spending, especially as purchases are likely to have been brought forward, effectively robbing the economy of future growth.

It is also the case that the US is likely to have a medium-term shortage of oil-refining capacity and this will tend to keep upward pressure on energy prices or force the US to increase imports. In either case, growth trends are liable to deteriorate.

Federal deficit will widen

There will be substantial federal spending associated with reconstruction efforts and, if there is substantial damage from hurricane Rita, there will be further government spending increases. Estimates suggest that additional federal spending could easily exceed US$200bn over the next 2 years. Construction spending will help support growth in the economy. The US government is, however, already running a high budget deficit in excess of 3.0% of GDP and there is only limited scope for increasing government borrowing without having an adverse impact on long-term interest rates.

Any sustained rise in bond yields would have a negative impact on the economy, especially as the housing sector is closely associated with the level of interest rates. Rising interest rates would risk a significant slowdown in the housing sector which would, in turn, increase pressures to curb spending levels.

There is also the threat that rising US federal borrowing will crowd out private-sector investment and this would undermine the underlying GDP growth rate.

Inflation concerns will continue

Inflation has already been pushed up be rising energy costs and the dislocation to key infrastructure will put further upward pressure on headline inflation in the short term. The Federal Reserve will be looking to prevent secondary inflation pressures and will, therefore, also be looking to increase interest rates further. The Fed will certainly be in a weaker position to support the economy through interest rate cuts if there is a sustained downturn in demand.

Market confidence vital

Overseas confidence in the US economy has remained firm during 2005 and this has allowed the dollar to remain firm despite persistent concern over the level of US external deficits. The confidence has, however, been built on expectations that US growth will continue to out-perform Europe and Japan. If this out-performance is in doubt, there will be an increased risk that overseas investors will pull funds out of the US. The US should, however, still be protected from severe pressure by the fact that Europe and Japanís growth prospects will also be weakened by the jump in energy costs.

A resilient performance by Wall Street would increase the potential for the US economy to weather the storm. A sustained downturn in the key US market would however, be damaging, especially as it would undermine domestic and overseas confidence in the economy.


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