Will global economic growth slip on another oil slick? That's a rising worry now that the price of petroleum has tipped back over $50 per barrel. For the U.S., strong income growth and sizable profit margins should enable consumers and businesses to weather the price rise. After all, the 2004 jump in energy costs caused little loss of momentum overall, although lower-income families were hit hard. However, this latest spike could pose a risk to the outlook if foreign producers react to their own slowdown in domestic demand by attempting to offset that weakness through increased exports. America's worsening trade deficit could trigger greater volatility in the dollar and global financial markets.
The markets' increasing nervousness was evident on Feb. 22. After a later-discounted report came out that the Bank of Korea would diversify its foreign reserve holdings, the dollar fell sharply in currency markets. Gold and oil prices rose and stock prices plunged. The Dow Jones Industrial Average lost 174 points on the day, its worst loss in nearly two years. Stocks rebounded somewhat the next day, but oil remained above $50 (chart).
This latest oil price rise comes at an especially bad time because some industrialized economies unexpectedly contracted in the fourth quarter. Japan's real gross domestic product fell at a 0.5% annual rate. Most of the weakness was weather-related: Three typhoons hit the nation in the fourth quarter. But the decline followed drops in real GDP in both the second and third quarters.
In Germany, real GDP fell at a 0.9% annual rate in the fourth quarter as domestic demand fell 0.8%. Also in the euro zone, Italy said its real GDP fell at a 1.2% annual rate at yearend. Meanwhile, monetary policymakers in Canada and Britain are hiking interest rates in an attempt to slow their economies.
For those countries struggling with growth, the problem is weak domestic demand, whether from high unemployment, business uncertainty, or the need to fix growing fiscal budget deficits. According to the consensus forecasts compiled by Blue Chip Economic Indicators before the latest oil rise, growth among the developed nations will be slower this year than it was in 2004. Now, global economies must also deal with the potential drag coming from continued high oil prices.
FOR EUROPE AND JAPAN, past currency movements mitigate some of the problem. That's because oil is priced in dollars, so their currencies' strengths offset some of the rise in energy costs. And Canada and Britain are energy producers who benefit from higher prices.
For emerging economies, however, the recent rapid rise in oil prices could exert a bigger drag on growth. First, many emerging nations, especially in Asia, have linked their currencies to the dollar or have accumulated massive amounts of reserves to stem the rise of their currencies. So these economies will feel almost the full brunt of higher oil costs.
Second, many developing economies are less fuel-efficient than more mature ones. China, for instance, uses 10 times as much energy to produce one unit of GDP as Japan does, while India needs 2 1/2 times as much as the U.S. That means higher energy costs will add more to the cost of doing business in developing countries than they will elsewhere. Consequently, higher oil prices are a bigger drag on domestic demand.
In the past, the response of many countries faced with slower domestic spending was to export their way to faster growth. Most often, that meant shipping goods to the U.S., the world's biggest purchaser of imports.
AND CLEARLY, the U.S. is growing at a fast enough clip that imports will continue to increase. Although total retail sales slipped in January, nonauto sales grew at a solid rate, and weekly reports on store sales show the gains continued into February. According to the Conference Board, consumers in February were more optimistic about the current state of the economy than they were in January. In fact, the board's index of consumer confidence for the present-day economy is finally back up to where it was before the September 11 terrorist attacks.
At the same time, businesses look more confident about the economy's direction. That can be seen in their willingness to green-light capital projects and build up inventories. The monthly data show growth in business inventories has been particularly stunning. In the fourth quarter, stockpiles grew by 7.8% from year-ago levels, the strongest pace in almost a decade (chart).
Faster inventory accumulation, along with increased consumer and business demand, makes it more likely that imports coming into the U.S. in 2005 could keep rising at the 10% pace seen in 2004. And while that will fit in well with the game plan of any foreign economy that wants to export more, the danger is that the never-ending flow of imports will worsen the huge U.S. trade imbalance.
ALREADY, ANALYSTS WORRY about what the U.S. can do to at least stabilize its current-account deficit, which probably hit 6% of GDP in the fourth quarter. But if imports keep growing at a double-digit pace this year, the trade deficit of goods and services will grow larger, not hold steady. Given that imports outnumber exports by 3 to 2, price-adjusted exports would have to surge by 15% just to keep the gap steady, with a 10% gain in imports. The last time real exports grew even close to that rate was back in 1997. And world growth clocked in at 4.2% then, much faster than what economists expect for 2005.
So far, of course, foreigners have been willing to finance America's huge trade gap. That partly reflects the better rates of return in the U.S. compared with other countries. But much of the financing by foreigners is in their own self-interest. By buying U.S. securities, foreigners provide the funding that enables the U.S. to keep buying their goods.
The unknown is this: At what point does the U.S. trade deficit get so high that investors turn away from the dollar? Up to now, the dollar's decline has been orderly, so that investors have absorbed its impact gradually. But as the Feb. 22 markets showed, a run on the greenback would have immediate negative impacts.
Inflation expectations would most likely rise sharply. Long-term interest rates, which have remained relatively low despite the six rate hikes taken by the Federal Reserve, would spike higher, sapping much of the energy from housing and autos. With borrowing costs rising, prospects for the federal deficit would worsen.
That could throw a wrench into any attempt to reform Social Security, since the plans under discussion have included massive upfront government borrowings. And the stock market would react negatively as well, rattling investor confidence and cutting into household wealth.
Right now, prospects for such a severe financial dislocation look small. But the uncertainty over energy prices raises a new concern for the outlook. Global growth could be slower than expected just when the U.S. needs to begin remedying its huge trade imbalance with the rest of the world.
By James C. Cooper & Kathleen Madigan