Monday, March 28, 2005

The 2005 Economy

The 2005 economy will grow more slowly than the 2004 economy. In fact, I estimate that 2005 U.S. economic growth will decline from above four percent for 2004 to less than three percent (annualized) by the end of 2005. Higher oil prices and higher interest rates will be the economic villains. Over the past year oil prices have risen by more than 50% and the prime interest rate has increased from 4.0% to 5.75%.

In general, oil price hikes reduce overall U.S. growth since U.S. consumers and businesses pullback on their purchases of domestic products such as haircuts and computers, and instead increase their foreign oil expenditures. Normally this situation would be self-correcting in that the U.S. dollar would fall making foreign oil even more expensive relative to domestic oil. Consumers would then begin to conserve energy and gasoline by carpooling and other “unpopular” measures. It has yet to happen. Despite rising oil prices and the plummeting dollar, U.S. consumers and businesses just cannot break their petroleum penchant. Great for Mr. Putin, bad for Mr. Bush.

Higher short term interest rates precipitated by the Federal Reserve Open Market Committee’s funds rate boosts will siphon dollars from the economy that might have been otherwise spent at the local Wal-Mart. For example, consumers will be paying higher interest amounts on credit card balances. There will thus be less money to spend on products and services that add to the quality-of-life---even lottery tickets.

Three percent growth will be acceptable and produce few significant problems for the U.S. economy. The real danger is that oil prices will move even higher and the Federal Reserve gets even more aggressive in raising interest rates. Additionally, if Asians become disenchanted with their meager investment returns denominated in dollars, long-term interest rates would rise and my three percent forecast would prove optimistic indeed.

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