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Country Outlook: United States
This article was originally published on November 17th 2005.
Country outlook
COUNTRY VIEW
FROM THE ECONOMIST INTELLIGENCE UNIT
OVERVIEW: In his second term in office, events in Iraq and at home are hindering the
efforts of the president, George W Bush, to advance an activist and ambitious domestic
agenda, despite Republican majorities in the House of Representatives and the Senate.
Mr Bush's approval ratings are still suffering from his, and the federal government's,
slow response to Hurricane Katrina, probably the most costly natural disaster in US
history. The clean-up and reconstruction costs are mounting and have direct
implications for federal finances, which will remain in deep deficit, given limited resolve
to curb discretionary spending. Monetary policy tightening will continue, as the Federal
Reserve (central bank) remains concerned about domestic asset bubbles and the risks
of higher inflation. Further interest rate increases will affect consumers, who are highly
indebted. Real GDP growth is forecast to slow from 3.5% in 2005 to 2.9% in both 2006
and 2007. Imbalances in the economy could trigger a less benign scenario. The US
dollar will come under renewed downward pressure in the final quarter of 2005 and
throughout 2006 and into 2007. The current-account deficit will reach 6.7% of GDP in
both 2005 and 2006 before falling back to 6.4% of GDP in 2007.
Domestic politics: Mr Bush may have come to the most critical juncture of his four and
half years in the White House. His approval ratings have sunk in response to continued
bad news out of Iraq, rising petrol prices and the federal government's feeble response
in the immediate wake of Hurricane Katrina in late August. The storm has raised
questions in the minds of many Americans about Mr Bush's leadership qualities and
abilities as a "crisis manager". His approval ratings improved marginally following the
more successful clean-up exercise after Hurricane Rita in mid-September, but still
remain near all-time lows in most opinion surveys, with his overall approval rating
hovering at around 40%. At the very least, the ambitious conservative agenda that he
outlined for his second term has been put on hold.
International relations: Mr Bush is resolved to stay the course in Iraq despite continued
violence and rising US casualties testing public support for the conflict. The message
from the Bush administration has become more realistic in recent months, reflecting
the difficulties faced by military intervention and the tough task of building a
democracy from scratch. But there are no signs of a change in policy. Sectarian
fragmentation and civil war in Iraq are a growing threat and could seriously undermine
US efforts in the Middle East.
Policy trends: The Economist Intelligence Unit forecasts that the federal budget deficit
will expand in fiscal year 2005/06 (October-September) and US interest rates will
continue to rise steadily. The deficit in 2005/06 was already expected to widen, as
government spending remains strong and the pace of economic growth continues to
slow. Now the clean-up and rebuilding costs related to Hurricane Katrina, initially
estimated at close to US$200bn, will be added to the budget. The latest interest rate
rise on September 20th--the Federal Reserve has tightened monetary policy in each of
its last 11 monetary policy meetings--placed the Federal funds target rate at 3.75%.
The central bank still considers monetary policy accommodative and has indicated that
rates will rise further at a measured pace. We expect the Fed funds target rate to
continue to rise steadily and reach 5% towards the end of 2006, as a more neutral
monetary policy stance is pursued.
International assumptions: The global economy continues to decelerate, following a
strong performance in 2004, although the slowdown is more gradual than we expected
just a few months ago. The structure of growth is also changing--world trade is
weakening sharply and domestic demand trends are becoming increasingly important
relative to external trade. The slowdown this year is likely to continue into 2006 and
2007, although the pace of expansion will remain reasonably favourable.
Economic growth: Real US GDP growth is forecast to slow from 3.5% in 2005 to 2.9%
in both 2006 and 2007. Our forecast of slower economic growth in 2005-07 is based
primarily on factors that predate Hurricanes Katrina and Rita. The impact of monetary
tightening on the financial health of the personal and corporate sectors is a major
concern. In general, personal debt relative to income is high, making consumers
vulnerable to rising interest rates. A greater share of personal income is being directed
towards debt service, which will increasingly squeeze consumer spending, particularly
in 2006. In addition, rising interest rates are likely to slow the house price boom and
could even push house and financial asset prices downwards. The stabilisation of
property prices at the very least will end the surge of household equity withdrawal that
has helped to fund much of consumer spending in 2004-05. Also, any downward
pressure on asset prices would undermine personal sector balance-sheets. This is likely
to lead to a rise in personal sector saving after years of decline--a trend that has
continued throughout 2005. The desire to save more, coupled with rising debt-service
costs, will cause consumer demand growth to soften towards the end of 2005 and
throughout most of 2006.
Inflation: Consumer price inflation has accelerated in the second half of 2005. Oil
prices have spiked upwards, reaching new highs in September, and will force up the
energy component of the consumer price index in the final months of this year as
consumers face higher petrol prices at the pump. More generally, higher energy prices
will raise production costs in most industries. A further difficulty for firms is the
likelihood that productivity growth will slow, while the major cost component for US
firms--unit labour costs--is creeping up and expected to rise further in 2006. Over the
last few years, higher costs have generally been absorbed by companies as consumers
proved too sensitive to price rises for firms to pass higher input costs on to purchasers.
Over time there is a risk that firms will regain pricing power. Accelerating price rises in
the second half of the year are expected to push up the average rate of inflation to
3.2% in 2005. In 2006 oil price and related pressures will remain strong and we
forecast that consumer prices will rise by an average of 3.3% before slowing slightly to
2.8% in 2007.
Exchange rates: Concern that the US will struggle to finance its large current-account
deficit and an increasing willingness among investors to diversify away from US dollar
assets underpinned a broad weakening of the dollar in 2001-04. In 2005 the dollar has
regained some strength, propelled by a combination of rising short-term interest rates
in the US and the weakness of other economies, notably the euro zone. We expect that
attention will return to the factors that sparked a weakening of the dollar in the first
place. We now expect the exchange rate against the euro to run at around US$1.22:€1
for the rest of the year. For the year as a whole, we forecast that the exchange rate
will average US$1.25:€1 and Y109:US$1.
External sector: The current-account deficit remains a significant fault line in the US
economy (along with the fiscal deficit and the high level of private-sector debt). We
expect the current-account deficit to widen to US$829bn (6.7% of GDP) in 2005 and
US$887bn (6.7% of GDP) in 2006, before reaching US$893bn (6.4% of GDP) in 2007.
The current-account deficit is driven to a great extent by developments on the capital
account; the US saves insufficiently to fund its own investment, necessitating huge
inflows of foreign capital and resulting in a large external imbalance. Within the current
account, the biggest single area of concern is the deficit in goods. Imports of goods are
(in cash terms) about three-quarters higher than exports. Even if the US consistently
manages to expand its exports a few percentage points faster than imports, the trade
position will continue to deteriorate. A significant improvement in the external position
would require a substantial slowdown in import growth relative to exports, but this is
unlikely in the absence of a collapse in the US dollar or a US recession.