Good, Gloomy, or Grim in 2005?

Growth tops the wish list, but even recession wouldn't be all that bad, given that recovery always follows. The big fear? Stagnation

By David Wyss

The economy looks set for a solid, if unexciting, 2005, with projected growth of 3.6%. However, a number of things could still have a dampening effect, including fears about rising oil prices, the falling dollar, higher interest rates, and the twin deficits. Here's an assessment of the major risks:

Oil prices: They're beginning to come down from their $55-a-barrel peak. At S&P, our baseline forecast expects oil to average $44 this year (about the same as in 2004) and $36 for 2006. But oil prices seem especially unpredictable now, given the uncertainties in the Middle East and the strong energy demand in Asia.

The U.S. dollar: The greenback is expected to continue dropping, but in an orderly fashion. We expect to reach $1.50/euro in early 2006.

Interest rates: The Fed seems locked into its policy of gradually raising the federal funds rate at every meeting. We expect them to stop at 4%. The surprise has been that long-term bond yields haven't risen with short-term rates. We expect a more normal relationship to hold this year, with the 1.75-percentage-point rise at the short end resulting in a 1-percentage-point rise at the long.

Federal budget deficit: We expect the deficit to drop from the record $413 billion set in fiscal 2004, but not in half as President Bush has said he wants it to. The appetite for controlling spending seems almost as nonexistent as the appetite for raising taxes.

U.S. trade deficit: The falling dollar will ultimately help, but it's worth remembering that after the 1985 dollar drop, it took two years for the deficit to shrink. Even if U.S. goods are more competitive, gains in market share need time to offset the rise in import prices created by the weaker dollar. It takes even longer if foreign markets aren't growing.

Productivity and inflation: The rapid rise in productivity over the last decade has been a major factor controlling inflation and permitting growth. We expect productivity growth to slow to 2.5% over the next four years, in line with its average since 1990 but above its 45-year average of 2.2%.

High uncertainty demands a range of possible outcomes, not just a "most likely" scenario. Some idea of the economy's sensitivity to the uncertainties is needed to assess the true risks. In addition to the baseline, I have run three alternative scenarios: recession (a late 2005 slump), optimistic (stronger noninflationary growth), and stagnation (the U.S. starts to look like Europe and Japan). The following table summarizes the differences:

  Possible Scenarios
Oil prices ($/barrel) Declining to $35 Jump to $75, then falling back to $35 Drop to $27 Holding near $50
Dollar (trade-weighted) Down 14% Down 17% Down 16% Down 10%
Interest rates Funds rate rising to 4%, 10-year yield to 5.5% Funds to 5%, then down in recession; bond to 8%, then down Funds to 4%, but not until 2007; bond to 5% Funds to 4.5%, bond to 8%
Federal deficit Down to $281 billion in fiscal 2007 Rising to $510 billion in fiscal 2007 Surplus in fiscal 2007 Near flat: $467 billion in fiscal 2007
Current account deficit Holds near $700 billion Rises to $800 billion in 2005, then down Rises to $775 billion in 2007 Rises to $750 billion in 2005, then edges lower
Stocks (2007 S&P500) 1332 1210 2176 786
Productivity (average) 2.40% 2.10% 3.00% 1.70%
Growth rates (real GDP) Hold near 3.5% Recession late 2005/early 2006, recovery begins late 2006 Hold near 4.5% Average 2.5%
Unemployment Holds near 5.25% Rises to 7% Drops to 4.3% Edges up to 5.7%
Inflation Averages 2% Up to 3.8% in 2005, down in 2007 Averages 1.5% Averages 2.7%

It's important to realize that higher oil prices alone don't cause the recession in our recession scenario, although oil goes back to the $75 peak that it hit (in today's dollars) in 1981. A rise in oil prices has to combine with higher interest rates and weaker consumer confidence, perhaps the result of Middle East events or terrorism in the U.S. Energy is a smaller percentage of consumer spending than it was back in 1981 (5% vs. 8%), and thus energy prices have less impact on consumers. Oil prices must hit about $150 a barrel to cause a recession by themselves. That level seems unreasonably high, unless the Middle East unravels completely.

Remember also that recessions tend to be brief -- the average duration is 10 months -- and are followed by recoveries. The 2001 recession was the mildest on record, with a peak-to-trough drop in real gross domestic product of only 0.5%, which is in part why the recovery was so slow.


  Higher growth -- the optimistic scenario -- cures the federal deficit problem fairly easily. With annual growth 1 percentage point higher, the budget is back in surplus by fiscal 2007. Stronger growth does not help the trade gap, however, because the U.S. growth sucks in more imports. The assumed productivity growth of 3% -- a good possibility -- matches the average of the last 10 years.

The scariest scenario is stagnation. This involves a reversion in productivity growth to the 1.7% average of the 1970s and 1980s, certainly a possibility. Weaker growth increases the federal deficit and pushes inflation higher. Weakness in Europe and Japan can still pull the U.S. down, if it becomes harder to finance the trade gap.

Our baseline forecast at S&P is relatively benign, with trend-like growth, lowish unemployment, and modest inflation. But to quote the great Yogi Berra: "Forecasting is difficult, especially about the future." We need to plan for what can go wrong, not just what we expect to go right.

Wyss is chief economist for Standard & Poor's

Edited by Patricia O'Connell

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