Acalin and Zilinsky -- How shaky is the American economy?
A pessimistic narrative about the U.S. economy is widespread. If it is true that economic growth will decelerate in the United States, the repercussions for the rest of the world would be severe. Slower growth in the U.S. would reduce demand for products exported by emerging markets as well as lower commodity prices -- which have already fallen sharply -- and make capital flows more volatile. Moreover, investors often view bad news in the U.S. as presaging broader problems for the global economy.
While the U.S. economy may not be firing on all cylinders, the outlook is probably not as bad as it appears in the latest economic indicators. There are at least four reasons why the U.S. economy may be stronger than it looks.
First, a contagion from Asia is less likely than it was at the beginning of this year. The supposed threat to the U.S. has typically been framed in reference to "global factors," such as the slowdown of the Chinese economy. But the Fed, the U.S. central bank, has removed its reference to external risks coming from the global economic environment in its last statement on the state of the economy.
Second, the current gross domestic product data may not necessarily reflect a slower pace of annual economic activity. While reported GDP growth was relatively slow in the first quarter this year, modest growth at the beginning of any year is fairly common. Moreover, statisticians often revise first-quarter estimates, and recent experience suggests that the economy may be expanding at a higher rate than the early data show.
Third, the benefits from the current situation in the oil market may soon become more evident in the U.S. The combination of a drop in oil and stock market prices following the disappointment with a lack of a production freeze agreement in December, and the increasing strength of the dollar, led the Fed to be cautious and keep interest rates unchanged in March. The situation looks more favorable today. The dollar has depreciated recently, boosting exporters' competitiveness. Oil prices have returned to their pre-December levels, increasing oil producers' profitability, and stock market prices have recovered.
Recent data suggest that U.S. shale production has reshaped the global oil market over the past few years. Due to rising incremental capacities and higher efficiency, there appears to be limited scope of oil price growth, unless there is a large spike in the demand for oil in the short run. This is good news for the U.S. economy: low oil prices have a positive impact on consumption through higher real income and on investment, assuming that prices remain in their current range.
Fourth, inflation may come back sooner than expected. The U.S. economy is currently experiencing modest but persistent GDP growth, coupled with minimal improvements in productivity. If productivity does not pick up and growth persists, the implication would be a fast fall in the unemployment rate. Without changes in current trends and monetary policy, unemployment could even fall below 3% by 2018. If this scenario materializes, inflation pressures would be likely to re-emerge. In that case, the Fed could need to rush to raise rates.
Given these trends, possible adjustments to U.S. monetary policy will be a key variable in the months to come. Is the Fed going to increase rates in June, before the vote in Britain and the uncertainty regarding the impact on the U.S. economy? Current implied probability from market participants is about 10 percent. A rate hike by July could also be postponed, especially if volatility around the Brexit referendum, scheduled for June 23, takes its toll on financial markets. Two rate hikes this year are "certainly possible," according to Fed officials, so a September move appears to be on the table.
However, markets still expect at most one rate hike this year: the pricing of market bets imply a probability of about 85%. This discrepancy between market expectations and comments from the Fed may cause an increase in volatility in the summer. Any surprises, of course, can come with adverse effects, as investors recently witnessed in Japan. The approach of the Bank of Japan -- delaying further stimulus during its last meeting after having earlier introduced negative rates -- resulted in an appreciation of the yen and a drop in Tokyo stocks. In the U.S., policy makers are still trying to find the right balance between signaling a likely rate increase with enough advance warning or, as has often been the case in recent years, risking a loss of credibility if a promised rate hike does not materialize.
Julien Acalin and Jan Zilinsky are research analysts at the Peterson Institute for International Economics.