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Expansion may be Dogged by Inflation


Earlier this year, following the acceleration in US economic growth from spring 2003 through to spring 2004, most economists ratcheted up growth forecasts. They were just in time to be caught off guard by the mid-year slowdown in payroll job growth, and quickly blamed the "temporary soft patch" on the rise in oil prices, which, of course, they should already have factored into calculations.

Ironically, when job growth spiked up for the month of October, they declared an end to the soft patch - never mind that oil prices had surged to record highs, too. They were surprised again when job growth fell back to earth a month later.

While higher oil prices obviously hurt US growth, the deceleration in growth was predictable last spring, based on ECRI's leading indices, well before the "soft patch" arrived. But many market players made the costly mistake of missing the wood for the trees - the oil price spike was only the tree in front of everyone's noses but it should not have obscured the broad cyclical slowdown that the leading indicators foretold before oil prices began to surge.

Their other mistake was to expect robust job growth just because gross domestic product growth had not slowed to a below-trend pace. In fact, there are three key aspects of the economy where cyclical turns can come at different times - economic growth, employment and inflation. While they are loosely related, the timing of cyclical turns in those key areas can be quite distinct. For example, it is quite possible to have strong economic growth with low inflation, as in the late 1990s, or a healthy recovery in GDP without a commensurate revival in jobs.

Understanding where we are and where we are headed in each of these cycles is critical. Because ECRI's leading indices of economic activity have been in clear cyclical upswings, it has been obvious that the economy would not be tipped into a new recession by any shocks, including the oil price spike. Because the growth rates of those indices had slowed by last spring, the deceleration in economic growth was on the cards regardless of oil prices.

Meanwhile, growth in the Leading Employment Index has also been easing since last spring. Thus, even with a continued economic expansion, job growth is likely to stay subdued for now. At the same time, in spite of lacklustre job growth and the deceleration in the economy, inflation pressures have remained elevated for months after bottoming a year ago. So it is not surprising that short-term interest rates have kept rising.

Many have long been concerned about a US housing bubble, believing that when it popped it would trigger the next economic downturn. The Leading Home Price Index, which has correctly predicted the sustained upswing in real home prices over the last few years, is still in a cyclical uptrend, although it has now flattened out. Thus, home prices are likely to hold up, although the pace of their advance should slow.

What does ECRI's array of leading indices have to say about the outlook for 2005? Prospects for job growth remain dull and inflation pressures are elevated. One point that needs to be emphasised is that this remains a resilient recovery, with no recession in sight.

Of course, a potential threat is the drop in the dollar. What the leading economic indicators are telling us is that even if a breakdown in the dollar leads to a crisis in the financial markets, it won't trigger a new recession. More to the point, in the memorable words of Treasury secretary John B. Connally: "The dollar may be our currency, but it is your problem."

The eurozone, where growth is already weak, will be under the most pressure from the weaker dollar, as it reduces the price competitiveness of its goods and services. It is actually a positive for growth in exports from the US and China, which has its currency pegged to the dollar. Still, in the foreseeable future, the lower dollar can merely cushion the slowdown in US and Chinese exports growth driven by a continued global slowdown.

But which way will growth turn by the end of 2005? There is a limit to how far leading indices can see. All we can say is "stay tuned".

Anirvan Banerji is the director of research for the Economic Cycle Research Institute.