Where is US Economy Heading?

Readers Question: Where is the US economy headed? Is it inflation or depression?

Recently, Goldman Sachs predicted a rough year ahead for the US Dollar. They forecast the dollar may fall against Pound Sterling to $1.85 in 12 months. Against the Euro, they forsee it to fall to $1.55 in a year’s time. Exchange rates are difficult to predict and they have a habit of defying market forecasts, but, the exchange rate forecast reflected some of the underlying problems with the US Economy. Basically, the recovery is in danger of fizzling out leaving a long period of high unemployment and sluggish growth. This will lead to lost output and a struggle to reduce the debt to GDP ratio.

Problems facing the US Economy

Rising Unemployment

Despite signs of economic recovery in the first half of 2010, US unemployment has continued to grow. This shows the economy is still showing signs of working well below full capacity. The rising unemployment is depressing confidence, investment and spending. It is also a further strain on government budget.

According to the CPS the national unemployment rate in the US is just below 10% (9.6%) worryingly there seems to be a lack of job creation. Furthermore many states are cutting back on expenditure to reduce budget deficits, this places more jobs at risk. CPS at BLS

Low Inflation. Official inflation is currently 1.1%. Some economists worry that stripping out volatile factors the inflation rate is even lower. This makes the US economy perilously close to deflation. The fear is that deflation could lead to a lost decade of growth similar to the Japanese experience. Inflation press release

Debt Deflation. Despite a rise in the savings ratio, the US consumer is still heavily indebted. Banks are still dealing with bad loans from the mortgage and credit crisis. The size of mortgage defaults means banks are struggling to lend like in more normal circumstances. Given the size of personal debt, a period of deflation would be quite damaging. It would increase the real value of debt and make it more difficult for people to repay it.

Budget Situation. Many states are struggling to reduce deficits. This is placing a fiscal squeeze at the state level. The Federal government has a large budget deficit and is reluctant to contemplate a further fiscal stimulus package.

Monetary Policy

US Monetary policy is already unorthodox. There is a record low interest rate. The Fed have indicated that the slowdown in recovery could encourage them to pursue a further round of quantitative easing. Given the low inflation rate and lack of other policy measures this seems to make sense. However, it is difficult to predict the effectiveness of this further monetary expansion. In liquidity trap, the creation of money and buying of assets may take time to boost demand.

Part of monetary policy is to actually try and increase inflation expectations. Usually Central Bankers are trying to do the opposite (reduce inflation expectations). But, the Federal Reserve are concerned that the US could gain deflationary expectations.

Exchange Rate Policy

Many in the US are concerned about the value of the dollar to Chinese Yuan. They argue the dollar is overvalued giving China an unfair competitive advantage. However, if the dollar does depreciate this should help boost exports over the next 12 months

US Economy at a Glance stats at Bea.gov

Overall

There is little chance of inflation in the foreseeable future. The US may avoid a technical recession (negative growth). H0wever, even if economy grows at a slow rate (e.g. 1-2% a year) it will leave a long period of high unemployment and spare capacity. It will be interesting to see how much quantitative easing will be able to revive the economy. This kind of policy is fairly unprecedented.

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By on October 20th, 2010

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