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Economic Outlook: Solid Growth for Now, but with an Inflationary Tilt

Author: Roger M. Kubarych
February 26, 2004
Council on Foreign Relations


Powerful stimulants are still at work in the United States, the main locomotive for global economic growth, as well as in China, a mounting source of strength for the entire Asian region. The sluggish Japanese economy will post its highest growth in almost a decade. Europe, both old and new, will experience moderate expansion, too. Even the debt-troubled countries of Latin America will record a significant growth pick-up. As a result, the world economy in 2004 will enjoy the best overall performance since the late 1990s.

The downside of this otherwise appealing scenario is that upward pressures on prices of commodities, services, and even many manufactured products are likely to materialize in several countries, including especially the United States and China. This stands in sharp contrast to recent years, when disinflation was the rule.

As for the United States, the economy is bolstered by these factors:

  • Exceptional fiscal thrust, which will add between 1% and 1.5% to growth all by itself this year;

  • Historically accommodative monetary policy, which will stay extraordinarily easy for several more months;

  • Low market rates of interest, as Asian central banks and governments especially acquire huge quantities of US Government securities;

  • Liberalized credit standards at lending institutions;

  • Eager buying of corporate and emerging market bonds by institutional investors who have become progressively less fearful of default risk in the past year and a half; and

  • The sizable depreciation of the US dollar over the past two years.

The impact of these stimulants is front-loaded. Boosted by continuing strong personal consumption and housing activity, increasing business capital expenditures, and a further rise in government spending, real GDP growth will probably expand in the range of 4% to 5% per annum in the first half of 2004. However, their collective influence will begin to diminish by mid-year, as consumers become more cautious and financial markets turn more volatile in the midst of what promises to be a tight and hotly contested presidential election campaign. Thus, the US growth rate will tend to settle back during the summer and fall. Once the immediate political uncertainties are resolved, growth will pick up for a while in early 2005, before the real debate on what to do about the huge Federal government budget deficit begins in earnest.

Meanwhile, China continues to boom. Economic growth may surpass 10% this year. It is led by massive plant and equipment investment, more than half of which results from heavy inflows of foreign direct investment. Most of that investment is going into subsidiaries and joint ventures of multinational corporations based in Asia, especially Japanese, Korean, and Taiwanese firms. Because they are providing capital equipment and other inputs to the production process, their exports to China are growing extremely rapidly. Many American (and also European) companies are also becoming more heavily involved in Chinese ventures, but that has not yet induced much higher exports to China.

In the United States, in particular, the inflation outlook is becoming less benign. During this decade, several exceptional developments have tended to hold down price pressures and suppress any tendency for them to reemerge. First is the profound difficulties, both economic and financial, within Japan. These caused an extraordinary retrenchment on the part of Japanese consumers and businesses alike. Actual deflation in Japan promoted disinflation in numerous global goods markets. Second is the collapse of the high-tech bubble, which led to severe dislocations notably in the telecommunications equipment industry and the personal computer business. Third are the problems of global excess capacity in a few major industries, especially motor vehicles and parts. Because of the high degree of capital intensity in car-making, firms found it difficult to adjust and maintained relatively high levels of production that could only be sold at deep discounts. Fourth the United States enjoyed several years of declining import prices, in the wake of a prolonged period of dollar strength in the foreign exchange markets. Fifth the almost overnight emergence of China as a major producer of consumer goods and many advanced investment goods put downward pressure on prices of a wide variety of products.

Taken together these factors pushed inflation rates for the US and several other countries down to levels that had not been experienced in over a half century. However, this "perfect storm" of disinflationary forces is not replicable. To the contrary, for the United States, traditional leading indicators of inflation are almost all pointed upward.

Future inflation is normally driven by commodity prices, unemployment (which influences wage cost pressures), and the value of the dollar. Some models also include industrial capacity utilization, but that has become less meaningful for a services-based economy like the United States. Because of the many lags between these underlying factors and the standard consumer price indexes, it is impossible to predict with much accuracy just when the effects will come through. But the direction of inflation is clear. Even Federal Reserve officials are on record predicting a rising inflation rate this year, although this has not fully registered with many bond market participants. Here is the evidence:

1. Commodity prices are up a lot.

  • Both the IMF's commodity price index excluding fuels and the CRB spot commodity price index are up by nearly 30% since the beginning of 2002 and about 15% since January 2003. US producer prices for raw materials are up even faster.

  • Some commodity analysts think that the Baltic dry index should also be considered as a global leading inflation indicator. It has skyrocketed from about 1000 in March 2003 to over 5000 recently. The explosion of Chinese trade has been largely responsible.

  • 100% of the components of the Journal of Commerce commodity index are up in price in the past year. That degree of unanimity has not happened since the 1970s (although the diffusion index has hit as high as 90 in 1987, 1991, and 2001).

  • Energy prices have a special impact as a leading inflation indicator, as they appear as both inputs and final products. They are up over 50% in the past two years, although just 10% since the beginning of 2003.

2. Unemployment rates are down.

  • The overall rate is down to 5.6%; the insured unemployment rate is down to 2.4%, compared to a record low of 1.6% reached in early 2000. These are rates at which wage pressures have surfaced in the past in the United States.

3. The dollar has fallen sharply against major currencies, especially against such important trading partners as Canada and Japan. Its impact, direct and indirect, is just starting to take effect but usually takes two to three years to work through in full.

  • One sign the impact is coming through: The PPI for finished consumer goods excluding energy has accelerated to a 3.4% annual rate, the highest rate in the past decade. Also the import price index moved up sharply in January 2004.

4. Capacity utilization is up. Though only modest so far, continued strong growth will raise utilization further in the months to come.

  • Manufacturing capacity utilization is back up to its highest level since 2001. [The far higher rates of the high-tech bubble are of questionable relevance, given that they mainly reflect the massive one-time increase in broadband capacity and some other high-tech products for which peak demand may never be regained.]

Sluggish adjustment to rising commodity prices and a falling dollar is not unprecedented. That was also the case in the 1970s. Today two additional factors retard the process. One is the aggressive use of hedonic price indexes for computers and autos. These adjustments for assumed quality improvements may be overstating the degree of actual quality improvement lately. The other is the use of "homeowners' rental equivalent" for attributing housing inflation. While defensible in theory, in practice the estimate is based on tiny samples which often give perverse signals, especially when home prices are rising fast and the share of the population that owns rather than rents goes up.

In an environment of rising inflation the Federal Reserve will eventually shift from its highly accommodative policy to a policy that is still quite accommodative by historical standards but involves moderately higher levels for the Federal funds rate. That process, which will fall far short of a genuine "tightening" of monetary policy, is being delayed by the lackluster growth of payroll employment and the still modest inflation rates recorded at the consumer level. But by the latter months of the year, it will be apparent that inflationary pressures are gathering, and the Fed will start responding to them.

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