Increased globalization has been kind to the Federal Reserve in recent years. Now, global influences are starting to swing the other way, presenting the Fed with some tough new problems as it tries to slow this overly rambunctious economy.
Since 1997, the mix of strong U.S. growth and weakness abroad widened the U.S. trade deficit, providing several benefits: Foreign producers acted as a safety valve for U.S. capacity constraints. The strong dollar kept imports cheap, a big plus for inflation. And foreigners were more than willing to invest their excess dollars in U.S. assets, especially New Economy stocks.
The coming year will be less kind, as the growth differential between the U.S. and the rest of the world narrows. The latest data, especially on housing, show that U.S. domestic demand is slowing. But demand in the rest of the world from Asia to Latin America to Europe is accelerating.
Certainly, Fed policymakers will not begrudge a rebound in the global economy. But the resulting speedup in U.S. exports will work against the Fed's efforts to cool off overall demand (chart). That means domestic demand in the U.S. may have to slow substantially if job markets and business activity are to loosen up enough to head off building inflationary pressures. This means the Fed may be far from finished with its tightening regimen, although a June 28 hike seems unlikely.
Moreover, as overseas economies improve, so will their investment opportunities. Any resulting flow of funds away from U.S. securities would exert downward pressure on the dollar. And a cheaper currency will only make U.S. exports more attractive in global markets while boosting import prices. The dollar is especially vulnerable now since the U.S. current-account deficit is at a record high, both in dollar terms and in relation to the overall economy. Edginess among foreign investors could create one more problem for the Fed.
FOREIGN TRADE began the second quarter on a very weak note. The April deficit for goods and services totalled $30.4 billion, virtually unchanged from March's record $30.6 billion. If the trade deficit remains around $30 billion in May and June, net exports would subtract more than a percentage point from overall gross domestic product growth in the second quarter.
April exports and imports were both basically flat from their March levels. As expected, aircraft exports rebounded strongly in April, but that gain was offset by weakness in shipments of vehicles and industrial supplies. The longer-term trend in exports, however, is decidedly up. April exports increased 11.3% from a year ago. In April, 1999, foreign shipments were flat.
The rebound in exports is evident around the globe, but the turnaround is strongest in the emerging markets hit hard by the financial crises of the late 1990s. During the three months ended in April, shipments to Latin America were up a huge 25.7% from a year ago, compared to an 8.4% plunge in the same period of 1999. Exports to east Asia jumped 14.7%, after no growth in the same period of 1999.
Looking ahead, exports to Europe, already rising 4%, may show particular acceleration in the second half. Economic growth in the euro zone should pick up considerably as domestic demand in Germany and France gains muscle. And the euro is strengthening against the dollar, making U.S. products more competitive on the Continent.
So far, export growth still isn't fast enough to offset the huge wave of imports that have caused the ballooning of the trade gap. Imports rose 21% in the year ended in April. Even excluding oil, imports are still up 18.4%. Weaker U.S. demand will slow imports eventually, but until that occurs, the trade deficit will be a drag on growth.
THE CURRENT-ACCOUNT DEFICIT--a much broader measure of U.S. foreign obligations that includes trade, net investment income paid to foreign investors, and unilateral transfers to foreign governments--will also continue to widen (chart). This gap rose to $102.3 billion in the first quarter, from $96.2 billion in the fourth, and the large April trade deficit means yet a larger deficit in the second quarter.
At an annual rate, the first-quarter current-account deficit equalled a record 4.2% of GDP, and by the end of the year, it will very likely approach 5%. That level is clearly unsustainable in the long run and one that puts the dollar at risk. The Fed will have to walk a fine line to avoid slowing the U.S. economy too much, to the point where foreign investors abandon U.S. assets.
WORRIES ABOUT THE DOLLAR, though serious, are not an immediate problem. A more urgent concern for the Fed: Faster growth in exports--which account for about one fifth of U.S. goods production--may be keeping U.S. manufacturers busy even as domestic spending eases up a notch.
Industrial production unexpectedly rose 0.4% in May, on top of a 0.7% jump in April. If June output manages even a small 0.2% gain, production in the second quarter will grow at an annual rate of 6.7%, about equal to the 6.6% rate of the first quarter (chart). Economists had forecast a drop in output last month because of the very weak May employment report. The Fed's data showing a gain in industrial activity suggest that the central bank's data crew had serious questions about the May job numbers.
Factory output alone rose 0.3% in May, with good gains in vehicles and information-processing equipment. Not surprisingly, the trade data show that exports of these goods have been rising at double-digit paces so far this year. Plus, the export-order index compiled by the National Association for Purchasing Management shows export orders increasing this year, including a big pop in May. If foreign demand keeps rising, manufacturing--and the economy in general--will not maintain the slower growth rate desired by the Fed.
One sector that is showing signs of a soft landing is housing. Starts fell 3.9% in May, to an annual rate of 1.59 million, led by a 5.4% drop in single-family starts. And in June, the National Association of Home Builders says its housing market index fell to a 2 1/2-year low of 58%. Still, mortgage applications remain strong, even with higher interest rates. As long as the job market is robust and confidence high, housing will weaken but not collapse.
Policymakers are trying to engineer a soft landing for the overall economy, in order to ease the building inflationary pressures that stem from growth of 6% for the past three quarters. The problem is that the U.S. economy is part of a greater global structure. Any production slack that opens up in the U.S. may be quickly filled by foreign orders. If that's the case, then Fed policy must be tighter to loosen up even more capacity. And the U.S. landing may end up being bumpier than is now generally expected.