Through TheFLY's Eyes: Money Matters

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Editor’s note: In our new “Money Matters” column, look for incisive commentary on this blog featuring a summary and analysis of the week’s most important issues affecting money, markets, and investing. It’s no-nonsense analysis timed to arrive when you have the time to read.


The U.S. Economy At Mid-2006


Four years into the current global expansion, it is not a stretch to state that the United States and global economy is entering a critical period. It’s appropriate, then, to review the economic health of both at this juncture, in mid-2006.

The U.S.’s $13.2 trillion economy continues to grow at a healthy rate in 2006, after registering a solid 3.5% GDP growth rate in 2005. In Q2 2006, the most recent quarter, the economy grew at a 2.5% rate after registering a red-hot 5.6% rate in Q1 2006.

The Fed’s Controlled Slow-Down

The deceleration in GDP growth in Q2 2006 primarily reflects a deceleration in orders for durable goods, equipment & software, private inventory investment, nonresidential structures, exports, and state & local government spending, partially offset by a deceleration in imports, services, and private inventory investment.

The deceleration also reflects the intentions of the U.S. Federal Reserve. The nation’s central bank, sensing that core inflation was above its targeted - or tolerated - rate of 1%-2% annually, began to increase short-term interest rates more than 2 years ago. Further, by pushing the discount rate up to 5.25%, the Fed also hoped its rate increases would take pressure off commodity and raw material prices. Commodities, and in particular oil, copper, wood, and steel, have experienced strong price pressures due to a surge in demand from the economies of developing countries (also called emerging markets): China, India, Central/South America, and Russia/Eastern Europe. And so far, the Fed’s monetary policy has succeeded. Growth has slowed in the U.S. to the aforementioned 2.5% growth rate in Q2 2006 and commodity price pressures have eased somewhat: commodity prices are now merely “elevated” as opposed to “increasing rapidly.”

Further, the adaptability and breadth of the U.S. economy, combined with its primacy on scientific achievement, efficiency, and private-market demand, and all supported by its dedication to the rule of law and belief in alienable rights, ensures that the nation retains its status as the most efficient, technologically-advanced, and sophisticated economy in the world in 2006. China’s vast population and growing economy offers a larger industrial output potential, Japan boasts more-advanced technologies is selected sectors, and Europe provides an enviable social compact, but no national economy offers as many goods and services available to the typical person, combined with the potential for return on equity, as the economy of United States. Its $42,000 per capita GDP, more than $50 trillion in investment capital, and 16 consecutive quarters of double-digit earnings growth for the S & P 500 speak to the nation’s persevering hard work, geographical advantages, and commitment to progress. In short, in mid-2006, the U.S. economy remains the preeminent economy in the world.

The Challenges Ahead

Nevertheless, the U.S. economy is not perfect: obstacles remain and there are problems that must be addressed.

The first problem is one the U.S. Federal Reserve may have created. In attempting to reign-in the economy to douse inflation at first flame, it may have slowed the economy too much. The Fed intended to take pressure off commodities, and slow a torrid housing sector by pushing the discount rate up to 5.25% but it may have underestimated the drag that higher oil prices place on the economy. Growth in consumer spending is slowing, along with business investment. If each slows too much, a recession will occur. At its last meeting in July, the Fed paused and did not raise short-term interest rates: it may need to continue that pause for several more meetings this fall, and be ready to lower short-term interest rates, if key indicators point to an end to GDP growth.

The second major problem concerns jobs. For reasons that are still not entirely clear, the current U.S. economic expansion is creating about 35% of the jobs created in previous economic expansions of similar length. Part of the reason is globalization – there has been job dislocation and jobs have left the U.S. for cheaper factories/production sites abroad – but part of it is also the U.S. economy itself: the U.S. economy has in-place technologies that enable increases in production without increases in manpower. That’s very good for the nation’s productivity and earnings capacity. It’s not as good for that displaced worker looking for his/her next job. Former Fed Chair Alan Greenspan argued that the way out of the job squeeze is adequate training and education at all levels of the economy. Chairman Greenspan was right, and the nation must commit itself to training and education at all levels to ensure that the U.S. is ready for the postmodern economy.

The third major problem concerns the budget and trade deficits. Regarding the budget deficit, national security and natural disasters have resulted in substantial increases in federal spending - spending that has exceeded revenue by eye-opening amounts. Simply, the nation will have to cut spending or raise taxes, or do both, to bring the budget back in balance. On the trade deficit, imports should slow as the U.S. economy slows in 2006, and that should reduce the trade deficit somewhat. Encouraging China to pursue a more-flexible currency policy will reduce the trade deficit further, by substantially increasing the cost of Chinese goods exported to the U.S.

The fourth major problem pertains to energy. The U.S. imports more than 50% of its crude oil and is far from energy self-sufficient. Even if one ignores the foreign policy implications of the nation’s dependence on foreign oil, there still is the search for new supplies / cost question: as major economies in China, India, Russia, and Brazil develop, competition for oil will increase. Most oil analysts argue that this will lead to higher prices long-term: higher than they are today, at about $70 / barrel. Hence, it’s in the nation’s long-term interest to develop alternate energy sources, as well as increase energy efficiency.

Outlook For 2006

Faster growth without inflation. More jobs. Better training and education to match those jobs. Lower budget and trade deficits. Less dependence on foreign oil and increased energy efficiency. That’s a full plate, to be sure, and this column hasn’t mentioned the geopolitical situation, which, as you’re probably well aware, has its own demands. But the U.S. economy is large enough and strong enough to take on all of the above concerns, and still flourish. And no less significant, the American people have always been industriousness enough and ingenious enough - and fair enough – to rise above even the toughest of challenges, which is why one should look for a better U.S. economy, and nation, up ahead in the second half of 2006.