Rising Oil Prices Are Slowing the US Economy

Gavyn Davies Gavyn Davies' Blog April 25, 2011

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The past week has seen new highs for the year in many major equity markets, including the US. However, oil prices have continued to climb in ominous fashion, and there have been some weaker signals from the initial economic activity indicators which have appeared for the month of April. In the US, for example, the important Philadelphia Fed index fell sharply, housing data continued to bump along the bottom, and initial unemployment claims were disappointing. Next Thursday will see the publication of the US GDP figures for 2011 Q1, which are likely to report quarterly annualised growth at only around 1.5 per cent, sharply down from the previous quarter. So why has the US economy slowed, and should we be worried about it?

The main problem in assessing the behaviour of the US economy at present is that the available economic data for Q1 have not painted a consistent picture. This is clearly shown in the following graph:

The red line on the graph shows the composite ISM business surveys for the manufacturing and non manufacturing sectors of the US economy on a monthly basis. The yellow histograms show the quarterly annualised GDP growth rates. These normally track the business survey results fairly closely, but this has certainly not happened since the beginning of this year.

Business surveys were remarkably robust in January and February, hitting high points which were barely reached in the whole of the last economic upswing. Even when business surveys started to weaken a little in March and (so far) in April, they remained consistent with growth in real GDP of around 4 per cent, which is well above trend. Furthermore, labour market data seemed consistent with this interpretation of the economy, with the growth in private sector jobs approaching 200,000 per month during the quarter.

So what is the problem? Unfortunately, the indicators of expenditure which are used to compile the GDP statistics do not confirm that the economy has strengthened in 2011. In fact, the reverse. The growth rate of domestic final sales is estimated to have slowed to only about 1 per cent in real terms in Q1, compared to 3.2 per cent in the previous quarter. The growth rate in consumption has roughly halved from 4.0 per cent to 2.2 per cent between the two quarters, and growth in fixed investment in equipment has similarly dropped from 7.7 per cent to about 4 per cent. On top of this, there has been a big collapse in spending on business construction, and government expenditure also seems to have fallen markedly.

Consequently, when the first official estimates of GDP growth in Q1 are published on Thursday 28 April, they are likely to show an economy growing at a very disappointing rate of only about 1.5 per cent, down from 3.1 per cent in Q4. Thus, in the period in which QE2 has been underway – a period in which equity markets have been celebrating the supposedly strong growth of the US economy – it now seems that real GDP grew at only about its trend rate. This is presumably why some members of the Fed’s FOMC have recently started to warn that the recovery in the economy might not be broadening and strengthening in the manner which had previously been indicated by the buoyancy of business survey data.

It is hard to be confident about whether the economy has now embarked on a prolonged period of slower growth. Business surveys have now dropped from their peaks, and there is no doubt that the rate of growth in the manufacturing sector will shortly drop markedly from the 9 per cent annualised rate recorded in Q1. The inventory cycle, which has been very bumpy in recent quarters, seems set to act as a drag on the economy in Q2 and Q3.

But the main problem is undoubtedly the rise in global oil prices, which have taken the price of gasoline almost back to the highs seen in 2008. This has drained consumers’ expenditure on all other items at an annual rate of about $100 billion in the past few months, enough to almost entirely offset the boost to spending which could have come from the extension of the payroll tax cuts in January.

So far, the oil shock has been largely dismissed as a concern by most economists, but it is clearly now becoming a significant drag on the growth rate in the US and elsewhere. It still seems probable that the underlying forces for recovery – which are based on exceptionally easy monetary policy, and the normalisation of financial behaviour by the private sector (implying higher spending and lower savings by households and firms) – will prove strong enough to keep the US economy growing at close to a 3 per cent rate over the balance of the year.

But this is now looking less certain that it did a few weeks ago, and it will be interesting to see whether the Fed downgrades its growth expectations when Ben Bernanke gives his first ever press conference following the FOMC meeting on Wednesday. Certainly, recent economic data do not seem to support any increase in short term interest rates when the Fed finishes its programme of bond purchases at the end of June.

I will be contributing a guest blog to FT Alphaville ahead of the FOMC meeting, and will be writing a live Alphaville blog while Mr Bernanke is speaking on Wednesday.

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Gavyn Davies is a macroeconomist who is now chairman of Fulcrum Asset Management and co-founder of Prisma Capital Partners. He was the head of the global economics department at Goldman Sachs from 1987-2001, and was chairman of the BBC from 2001-2004.

He has also served as an economic policy adviser in No 10 Downing Street, an external adviser to the British Treasury, and as a visiting professor at the London School of Economics.

Rising Oil Prices Are Slowing the US Economy

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