The U.S. economy is at a crossroads. The latest data show demand and output began the second quarter on weak footing, and new talk of deflation only adds to questions about the future. At the same time, prospects for stronger economic growth in the second half are the best in a long time, mainly because financial conditions are exceptionally favorable, consumer confidence is reviving, and federal tax cuts are expected to lift consumer demand.
Federal Reserve Chairman Alan Greenspan remains cautiously optimistic. In testimony before the Joint Economic Committee of Congress (JEC) on May 21, Greenspan said that recent economic data still reflect business decisions made prior to the Iraq war, but that economic fundamentals "augur well for the future." The central question about the outlook, he said, remains capital spending, now that war uncertainties are ebbing.
After the Fed caused a stir in early May by raising worries of deflation, members of the JEC were quick to ask the chairman about these concerns. Greenspan went to great lengths to tell the committee that the odds of deflation in the U.S. are small, but that a continued fall in inflation could be detrimental (chart).
What Greenspan left unsaid was that the dollar's decline will help to reverse this disinflationary trend. It could also help capital spending by boosting pricing power and profits. Ultimately, a better profits outlook is the key to the business-sector recovery.
IT'S IMPORTANT TO RECOGNIZE that not all deflation is created equal. Prices that drop because of innovation and more efficient production processes are a primary benefit of technological advances. That's why the Fed never mentions deflation in the context of ever-cheaper computer power.
The fear is that weak demand coupled with excess capacity would force companies to reduce prices to drum up business. To salvage profit margins, they would cut workers' salaries, depressing income growth at a time of heavy consumer debt. Households would have to devote more of their shrinking paychecks to paying off IOUs, leaving less money to spend and triggering a new round of cost-cutting. If businesses and consumers can't pay back loans, the financial system would be at risk. And lower interest rates wouldn't reverse the process, because no one would borrow to buy goods that might be cheaper in a month or so.
Greenspan believes the U.S. is nowhere near this downward spiral. But to play it safe, the Fed wants both consumer and business demand to rise substantially to soak up excess capacity, create jobs, and generate some pricing power. Although the Fed chief always defers to the Treasury Secretary on the subject of the dollar, the Fed must be watching the currency markets closely. That's because a depreciating currency is tantamount to an easing in monetary policy. So in the short run, the dollar's drop will be very supportive of growth.
A weaker greenback gives U.S. exporters a price edge in global markets. Foreign shipments have been stagnant for more than a year (chart), contributing to the decline in the U.S. factory sector. Industrial production, which hasn't posted an increase since January, fell 0.5% in April. Manufacturing output alone slipped 0.6% last month, the third consecutive decline. But manufacturers are "optimistic" about exports in the second half, says the semiannual forecast survey done by the Institute for Supply Management. The survey shows 45% of companies that ship overseas expect exports to pick up, and only 9% foresee declines.
Of course, a revival in U.S. exports will depend heavily on better global growth. And the dollar's slide may indirectly help out, because the corresponding strengthening in the euro is raising calls for the European Central Bank to stop worrying about inflation -- which is hardly a problem -- and concentrate on boosting growth by cutting interest rates.
ON THE DOMESTIC FRONT, the lower dollar aids the Fed in its effort to combat disinflation. Already, the weaker greenback has triggered an increase in the prices of nonoil imported goods. Such prices fell sharply throughout 2001, reflecting the dollar's climb. But since then, prices have trended higher; by April, nonoil import prices were up 0.9% from the year before. So far this year, they are rising at a 2.2% annual rate.
Climbing import prices take pressure off U.S. goods-producers to cut their own prices to stay competitive. If a sinking dollar makes imports even more expensive, U.S. manufacturers can begin to put through actual price increases. That would be a turnaround from recent pricing trends. Consumer-goods prices, excluding food and energy, fell 1.8% in the year ended in April.
No one expects goods prices to soar. There is too much excess capacity both in the U.S. and the world to allow a serious runup in inflation. In April, U.S. factories used only 72.5% of their capacity (chart), and they have been laying off workers for the past two years.
Indeed, one of the main differences between today's experience and the mid-1980s, when the dollar also weakened considerably, is that capacity utilization by the end of 1987 was running at more than 83%, factory payrolls were expanding, and goods prices were already rising by close to 4% yearly.
MOREOVER, AN UPTICK in goods prices won't trigger inflation fears because service inflation is slowing. Thanks to some moderation in shelter and medical-care prices, core service inflation in April was running at 2.9%, down from 4% the previous year. And since most service industries are insulated from foreign competition, the dollar's slide will not push up service prices. The combination of some inflation in goods and less in services will yield tame overall inflation.
Although the dollar's decline should benefit the economy in 2003, it's important to realize that any sustained drop in the currency could also be detrimental to the long-term outlook. A continuous increase in import prices would mean a fall in real income and a slowdown in personal consumption.
Also, U.S. financial assets could become less attractive, just as the Treasury must sell more bonds to cover Washington's ballooning deficit. The loss of foreign investors would also hurt the stock market. Consequently, the Fed will be on guard that the dollar's slide doesn't become a free fall.
Just two days before Greenspan's testimony, the JEC issued a report detailing the actions available to the Fed with interest rates already low. Among the policy choices was intervention in the currency market. By purchasing foreign securities, the Fed could expand reserves and pursue an easier monetary policy. But that's already happening. The currency markets, by bidding down the dollar, are doing the Fed's easing. And the U.S. economy will be the beneficiary.
By James C. Cooper & Kathleen Madigan