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The coming US slowdown and its global impactnews
Rex Mathew
11 August 2006

Some economists worry whether the US Fed has already gone too far with its rate hike campaign and the US economy may face a recession by next year. If so how would US recession affect global economy?

As widely expected, the US Fed has kept the target Fed rate unchanged at its meeting earlier this week. The Fed rate currently stands at 5.25 per cent per annum, after a 2-year long rate hike campaign, which started in June 2004 when the rate was at a nearly 50-year low of 1 per cent.

The Fed, under former chairman Greenspan, had reduced rates consistently after the tech bubble burst to help the US economy recover. As the growth momentum was regained, the Fed started hiking rates in a series of ''measured'' steps of 25 basis points each. These rate hikes helped keep inflation at manageable levels, if not below the Fed''s own targets, when the US economy enjoyed a period of good growth.

Under its new chairman Ben Bernanke, the Fed raised rates twice earlier this year before deciding to pause this week. Being new to the job Bernanke had to establish his inflation-fighting credentials, which both his immediate predecessors – Greenspan and Paul Volker (yes, the same Volker whose report was used by Natwar Singh''s detractors to put him in the dock) - were famous for.

But the decline in some of the major economic indicators over the last few weeks have prompted many economists to worry whether the Fed has already gone too far with its rate hike campaign. They have also started worrying whether the US economic growth would slow down considerably in the coming quarters and, worse still, the possibility of the US economy falling into a recession by next year.

Is the US slowdown going to be so bad? What triggered fears of a US recession was a steep fall in US GDP growth for the April-June 2006 quarter to 2.5 per cent per annum from as high as 5.6 per cent for the Jan-March quarter. Growth was expected to decline during the quarter, but not so dramatically.

These fears were heightened on lower than expected job additions and surveys showing a slowdown in the services sector. Business spending has already lost momentum and consumer spending has shown signs of following suit.

Even after all these adverse data, most economists still expect the US economy to grow at around its long term average rate of 3.5 per cent per annum for the full year 2006. They reckon that even if growth remains subdued during the third quarter, there would be a modest pick up in the fourth quarter.

Skeptics argue that the full effect of past rate hikes by the Fed has not yet reflected on growth rates, something which the Fed also acknowledges in its statement released this week. While the Fed is taking this as a positive thing for its moderating impact on inflation, some economists worry that this pass through effect would pull down growth rates in the coming quarters.

It is generally accepted that it takes around a year for the full impact of a rate hike to pass through. That is why central banks all over the world are always worried about being ''ahead of the curve'' or having the ability to anticipate trends.

The main driver of US economic growth over the last few years has been rising property prices. Though real wages in the US economy have remained near stagnant, consumer spending remained robust as high asset prices lifted consumer spending. Very low interest rates fuelled a home re-financing boom, which left sufficient cash with consumers. Critics of former Fed chief Greenspan have often blamed him for replacing the ''tech bubble'' with a ''property bubble''.

Over the last year, property prices in the US have stagnated and even declined in some areas. This has led to a considerable fall in home re-financing, which is clearly affecting consumer spending.

The real worry is that any further rise in interest rates would see further declines in property prices, if not a crash. Lower consumer confidence would affect spending, especially since real wage growth is not expected to improve. A slowdown in consumer spending is always the worst news for the US economy, nearly 70 per cent of which relies on domestic retail consumption.

Any pass-through effect of past rate hikes would make the outlook more bleak, especially for the next year. Suddenly the US economy, which looked reasonably robust till about a month back, appears to be sliding downwards and appears more vulnerable to external shocks.

Oil prices can provide a shock The biggest possible threat to US economic growth at present is rising crude oil prices. Shutdown of the largest oil production facility in Alaska has sent crude oil prices to near record levels and oil at $80 per barrel seems very close to reality.

If the Middle East crisis worsens and the hurricane season in the Gulf of Mexico is as bad as it was last year, oil prices can rally much above $80 per barrel. That would be a significant blow to consumer confidence as higher energy costs would eat into disposable consumer income.

Global rating major Standard & Poor''s has forecast a bleak scenario for the US economy if oil prices rise above $80 per barrel. If oil sustains above that level, the agency expects US economic growth to slip to 2.5 per cent per annum in 2007.

The S&P forecast considers only the impact of higher oil prices. The growth rates would be even worse if other variables also turn adverse. The S&P report further states that the US economy would be much more vulnerable to other shocks as growth rate slows down.

Will inflation in the US ebb? Consumer inflation in the US was at 4.3 per cent for June and core inflation, after removing energy and food prices, at 2.6 per cent is well above the Fed''s target range. The fact that prices have not come down despite the decline in growth rates during the second quarter has many economists and analysts worried.

The US Fed is clearly betting that the slowdown in economic growth would cool inflationary pressures in the coming quarters. But that is a very risky bet and one that can easily go wrong. If US inflation does not ease in the near future, the rate hike pause by the Fed would turn out to be a case of inaction having a deeply distressing impact.

Till last year, US inflation was held under check mainly through productivity gains. But recent data indicates that such gains are waning fast and a period of productivity decline may possibly be near.

Cheaper imports of goods and services, the latter through outsourcing, have also helped control inflation in the past. This would change if the US Dollar were to lose ground against other currencies, making imports costlier. Most economists and investors like Warren Buffet expect the ''dollar'' to lose value because of the US current account imbalances.

Those are the risks, but it is also possible that US inflation would decline in the near future as expected. Money supply growth has already declined and real growth in money supply, adjusted for inflation, may have already turned negative. This may lead to a further cooling off in spending, both by businesses and consumers, and keep inflation under check.

Stagflation! Really? This is the worst-case scenario: US inflation continues to rise despite a decline in economic growth rates. The Fed is forced to raise interest rates further to fight inflation and the US economy slips into a period of recession. More skeptical economists and analysts have started worrying about the probability of stagflation – rising inflation when economic growth is declining – though it seems unlikely at least for now.

In such a scenario, the imbalances in the US external account can either improve or worsen. If it worsens, we may face a global financial crisis - the kind of which we have not seen before.

Slowdown in other parts of the globe would lead to lower demand for US goods, especially heavy equipment. As export growth declines, the trade deficit may worsen and exert further pressure on the US dollar. A readjustment of imbalances in such an environment can be very painful.

But a slowdown in the US economy may also lead to lower imports and in turn an improvement in the trade account deficit. Slow growth in other parts of the globe may also lead to higher investment flows into US assets, which are considered the safest in times of uncertainty. Such flows would protect the dollar from declining appreciably.

Impact on global growth Most forecasts, including those by IMF, expect the global economy to sustain growth rates of over 4 per cent next year as well. These forecasts are based on the expectation that US economic growth would be closer to 3.5 per cent per annum.

If the US economy slows down considerably, it would also pull down global growth rates even without considering the peripheral impact on other large economies. Other central banks would also be influenced by any future Fed decision to raise interest rates.

Economies, which rely considerably on exports to the US, would be the worst hit. Japan may slip back into recession as demand for autos, consumer electronic products and other equipment declines. Most countries in South East Asia, which depend heavily on exports, would also be equally affected.

The impact on China would depend on how fast it can boost domestic consumption to become the prime driver of its economy. The Chinese government is making an all out effort in this direction and the country may escape much damage.

But if there is a sharp decline in global growth, the structural imbalances within the Chinese economy may worsen the impact. If investment flows into the country slowdown and the known skeletons in its closet like the huge bad loans of banks turns out to be even uglier, China would go through some pain. If some unknown skeletons emerge in this turbulence, deeper would be the pain.

India would also face some difficulties, but would be better off than most other large economies. Export growth would decline and sectors like IT and BPO services which are dependent on overseas markets would naturally be worse off than others.

These difficulties would worsen if oil prices remain well above $80 per barrel. But the probability of India''s GDP growth rates slipping much below 6-7 per cent per annum in the medium term is low, unless the monsoons also fail.

Hopefully, none of this would happen and the global economy would continue to maintain its current growth momentum for at least another couple of years. But, undoubtedly, the risks to such growth have gone up considerably in the last few weeks.

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The coming US slowdown and its global impact