US growth weak - but all is not lost

The great US economic boom has come to an abrupt end. The pace of economic activity has weakened considerably since the middle of last year. Output as measured by GDP rose by just 2 per cent in the third quarter and 1 per cent in the fourth quarter of 2000.

Today will see the release of GDP figures for the first quarter of 2001. These are expected to show that the US economy expanded at a rate of just 1 per cent again for the second quarter running. The figures compare with GDP growth rates of 4 per cent to 5 per cent in the latter half of the 1990s.

The strong growth performance of the US economy during the late 1990s was very much supply-side driven, reflecting improving productivity and substantial capital investment in new technologies. Not surprisingly then, evidence of the slowdown in activity has been most pronounced in the high-tech sector and in a marked weakening of business investment.

In addition, there was a substantial build-up of unsold goods last year as demand weakened under the weight of higher interest rates and rising oil prices. Manufacturing output has fallen by 2.5 per cent since September, as firms run down stocks and move to bring production into line with slower demand.

Despite the contraction of industrial output and business investment, other sectors of the economy continue to expand. Consumer spending continued to rise in the opening quarter of 2001, albeit at a much slower pace than in recent years. Housing starts also strengthened, while construction spending as a whole rose strongly over the winter months.

A marked divergence of views has emerged about the depth and duration of the slowdown in the US economy.

Some analysts expect a US recession while others think that the economy can avoid a recession and stage a modest recovery in activity later in the year. To be perfectly honest, it is uncertain which outcome will prevail. There is little disagreement, however, that the pace of growth will remain very weak in the second quarter.

The corporate sector continues to report a difficult trading environment - labour market conditions are deteriorating as lay-offs increase and stocks are likely to be run down further, restraining output growth in the industrial sector.

Meanwhile, any recovery in business investment is a long way off because of considerable excess productive capacity, especially in the technology sector.

Nonetheless, a number of factors suggest that having skirted with recession in the opening half of 2001, a moderate upswing could take root in the economy over the second half of the year. In particular, unlike in previous cycles, low inflation has enabled the US Federal Reserve to ease policy early and aggressively in this downswing. Interest rates have been cut by 2 per cent year to date. This could prove decisive in preventing a recession and triggering an early recovery in activity. Furthermore, long-term interest rates, including mortgage rates, have fallen over the past year, which is helping to underpin activity in the housing sector.

Meanwhile, lower oil prices are providing a boost to real disposable income, while the Bush Administration's tax cuts should start to take effect later in the year.

The resilience of consumer spending in the face of the severe setback endured by equity markets over the past year and the general economic slowdown evident since last summer is also encouraging. Helped by this, the inventory overhang should be worked off this summer, which should pave the way for a pick-up in the hard-hit manufacturing sector.

Monetary policy, however, is going to be driven by the considerable downside risks facing the economy in the coming months.

The Fed is clearly focusing on factors restraining economic growth, such as the downward pressure on corporate profit margins, excess productive capacity and the inventory overhang. These factors will continue to depress the pace of economic activity for some time, especially capital spending. Furthermore, labour market conditions are worsening with job lay-offs increasing, the unemployment rate edging upwards, and with the largest decline in payrolls in a decade being recorded last month. Combined with the weak equity market, this could trigger a rise in personal savings, resulting in a downturn in consumer spending. Such a development would represent a major threat to hopes for an upswing in activity later in the year.

Clearly then, further monetary easing is on the cards. The market is looking for another 50 basis points (bps) cut in the key funds rate, bringing it down to 4 per cent.

The Fed, however, is unlikely to take any chances with the fragile economy. With activity remaining weak in this quarter, rates could well be cut by another 100bps to 3.5 per cent in the months ahead.

Oliver Mangan is chief bond economist, AIB Group Treasury