Thursday, April 28, 2005

When Does A Soft Patch Become a Sink Hole?

Gross Domestic Product, the measure of all the goods and services produced by both the public and private sectors in the United States, grew at just 3.1% in the first quarter of 2005 after Wall Street analysts had predicted 3.6% growth, more evidence that the economy has hit a "soft patch". GDP growth is the slowest in two years. Economists are blaming high energy costs and higher interests rates for the slowdown in consumer and business spending.


Federal Reserve Chairman Uncle Alan Greenspan has already raised interest rates a quarter point seven times to fight inflation creep and is expected to approve another rate increase next Tuesday when the Fed meets for power sandwiches. Wall Street was hoping that Greenspan would start to ramp down on the rate increases with the economy apparently slowing in the first part of the year, but inflation remains a worry for the Fed. The latest GDP report won't assuage fears of inflation, with personal consumption expenditures excluding food and energy rising 2.2% in the first quarter of 2005, up from 1.7% in the final quarter of 2004 and the biggest increase since the last quarter of 2001.

Business investment was also considerably weaker, falling from a 14.5% annual growth rate in the final quarter of 2004 to just 4.7% in the first quarter of 2005. Consumer spending fell from 4.2% annual growth rate in the final quarter of 2004 to 3.5% in the first quarter of 2005. In the third quarter of 2004, personal consumption expenditures had been 5.1% annual growth rate.

So what does this all mean for the economy? Writers at Reuters and the Wall Street Journal are careful to use words like "softened" when talking about the growth in the United States economy, stressing that 3.1% is modest growth, but still growth. They both note that growth is supposed to slow even more in the second quarter of 2005, primarily due to higher energy costs and lower consumer spending, but that stagflation or recession are not currently a worry yet.

Now I'm no economist, but I want to say a few things about the current state of the U.S. economy and see if they make some sense.

Consumer spending revs the U.S. economic engine. Much of consumer spending has been fueled by debt. Interests rates are rising, albeit slowly. Prices are rising, not so slowly. Consumers are spending less and trying to pay down their debts (especially with that new Bankruptcy Law signed by President George MBNA Bush last week). So the economy is slowing down while inflation is increasing. Uncle Alan will still be raising interests rates, further squeezing borrowers. The housing market, the only part of the economy still rolling, will eventually have to slow down because of rate increases. Real Estate values will decrease as rates increase, since much of the real estate market has been moving on adjustable rate mortgages. As borrowers start missing payments on their mortgages and banks start foreclosing, overly inflated real estate values (the so-called Housing Bubble) will return to earth because quadrupled real estate value in just two years seems a little unreal, doesn't it? Meanwhile, business spending decreases as inventories and energy costs increase, further decelerating economic growth. The trade deficit, already at a record level, further hurts business, as Americans purchase cheaper foreign goods from Asia over homemade American products. Unemployment, already historically high for an economic recovery, will increase as business stop hiring (or start laying off again) during the slowdown. As bankruptcies and house foreclosures increase, the U. S. economy teeters on the edge of recession.

Most economists scoff at the notion that we could head into a recession later in the year. But with Japan (o.8% growth) and Germany (o.7% growth) already heading into recession and U.S. growth decelerating faster than expected, of course it's a possibilty. Economists were originally forecasting 4% GDP growth for the first quarter of 2005, than they lowered growth expectations to 3.6%. GDP came in at 3.1%, 0.9% lower than originally predicted. Wall Street is predicting 2.5% - 3% growth in the second quarter of 2005. What happens if it comes in lower than expectations, say 2% or 1.5%? With oil still above 50 dollars a barrel and price pressures continuing, the Fed doesn't have much wiggle room with interest rates. With a record Federal Budget Deficit, Bush can't cut taxes or increase government spending to make up for the shortfall in private sector spending. So where does the economic impetus come from?

As I said, I'm a novice at economics and I'm just talking basics here. But doesn't it seem like the U.S. economy, propped up by consumer debt and an overinflated real estate market, is a house of cards that could tumble at any time?

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