Is the 2005 economy headed for a spring break like that of 2004? The cause of last year's second-quarter soft patch can be summed up in three words: oil, oil, and oil. Spiking energy prices curtailed growth, especially for consumer spending. Now the worry is another slowdown, given that the average gasoline price hit a record $2.28 per gallon in the week ended Apr. 11.
However, the economy this year is in much better shape than it was last year. First of all, consumers are benefiting from stronger job markets. Second, the financial markets are easily absorbing the series of Federal Reserve tightenings, and long-term interest rates are lower now than they were last May and June.
Finally, the business sector is more willing to spend than it was in the past. One aspect of the latest oil spike is that businesses are using energy costs as a reason to raise prices generally. Business will play a much bigger role in the expansion this year thanks to better pricing power across more industries.
All this is not to imply that costlier oil isn't negatively affecting the economy. It is. Weaker-than-expected March retail sales, along with recent consumer-confidence measures and surveys of businesses, suggest that higher energy bills are curbing some optimism and spending plans. And in coming weeks additional data for March and April could show a bit of softness. Higher oil prices are also contributing to the widening of the U.S. trade deficit, which by itself probably subtracted at least one percentage point from growth in the first quarter.
It is worth noting, though, that although crude-oil prices have been on an upward climb for a year, the U.S. economy managed to grow almost 4% in the same period. Moreover, by mid-April, oil was sharply below its recent peak of $57. The key here is that the new round of oil-price hikes comes at a time when overall demand is sturdier and more widespread than at any previous point in this expansion. Shocks usually cannot derail a well-balanced and growing economy. Struggling economies are more at risk. Just look at the euro zone.
FED POLICYMAKERS took note of the U.S. economy's momentum during their Mar. 22 meeting. In the minutes, released on Apr. 12, the Fed discussed the strength of U.S. demand and its potential effect on inflation.
The minutes said strong income gains and higher wealth are supporting consumer spending, which is on track to post another healthy advance in the first quarter. Business spending on equipment, outside of cars, seemed to be growing briskly last quarter, the Fed noted, adding that the positive outlook for business investment could be attributed to steadily rising sales, an ongoing need to replace and upgrade software and equipment, and favorable financing costs. Inventory building probably also contributed to growth in the first quarter. Overall, the Fed's staff projected that the economy would most likely grow faster than its long-run potential, a pace generally accepted to be about 3.5%, both this year and next.
One crucial assumption at the late March meeting was that oil prices would "level out or decline a bit." But some attendees noted that "a significant unwinding of higher energy costs might not be in prospect." Moreover, anecdotal reporting by the Fed showed business executives believed robust demand and a weaker dollar meant "a degree of 'pricing power' had returned."
The Fed appears to expect higher energy costs will exert a small degree of pressure on nonenergy prices. But how small will depend on how robust demand remains this spring and summer. If businesses can pass along bigger-than-expected price increases, policymakers would most likely lift interest rates more aggressively.
THAT'S WHY CONSUMER BEHAVIOR in the face of higher energy prices is worth watching. Indeed, the Fed may be expecting higher energy bills to slow consumer spending, as it did last spring. In March, when gasoline prices averaged $2.08 per gallon, up from $1.91 in February, retail sales rose only 0.3%, after a 0.5% increase in February. Sales at gas stations jumped 2.1%, almost all due to higher prices. But excluding gas purchases, retail sales still increased 0.1%.
For the entire first quarter, retail sales exclusive of gasoline and autos grew at close to the same pace they did in the fourth quarter. The showing suggests real consumer spending on all goods and services increased at an annual rate in the neighborhood of 3.5% for the quarter. Such a vigorous pace supports the forecast that real gross domestic product expanded by about 3.5% last quarter.
Why is energy exerting less of a drag on consumer spending this time around? One reason is that $2-a-gallon gas no longer carries the sticker shock it once did. Also, as the Fed noted, consumer finances and the outlook for the labor market are much rosier now than a year ago.
For instance, the unemployment rate was a half-point higher in March, 2004, than the 5.2% hit in March, 2005, with 2.1 million more jobs created over the past year. Real aftertax income is growing at a solid 3.3% from its year-ago levels. In addition, households are getting more cash back from Uncle Sam. For tax returns certified by Apr. 8, refunds are averaging $2,189. That's up 4.7% from the comparable 2004 period. Those larger checks will let consumers cover their higher energy bills and still spend for other goods and services.
ONE AREA WHERE OIL should exert a continued drag is the trade sector. The U.S. monthly trade deficit hit another record in February, rising to $61 billion, from $58.5 billion in January. Higher oil shipments, along with a jump in imports of phamaceuticals, caused imports to rise 1.6% in February. Exports were virtually flat.
Oil imports surged 10.3% in February. Expect them to rise into the second quarter. That's because February marked only the start of the recent hike in oil prices, and refiners will be boosting their imports of oil in order to produce gasoline for the all-important summer driving season.
But oil was not all to blame for the worsening trade deficit. Real imports of nonauto consumer goods have gone up over 20% over the past year. One reason is the end of quotas on textiles and clothing at the start of this year. Apparel and consumer textile imports rose 14% in the first two months of this year compared with the same period of 2004, while textile jobs in the U.S. dropped by 17,000 in the first quarter, the largest loss in more than a year. Most of the new textiles are probably being shipped from China, a trend that is contributing to the political tension between that economic powerhouse and the U.S.
The bump up in textile imports illustrates a crucial piece of the U.S. economic outlook. Domestic demand is so strong, it is boosting production both in the U.S. and overseas. This solid, broad base of demand is why oil has so far not hampered growth. Unless a surprise supply disruption causes oil prices to skyrocket, the economy should be able to weather the oil-price sequel of 2005.$tx
By James C. Cooper & Kathleen Madigan