US Economy Projected to Grow 3.6 Percent, Deficit Too High

Location: Washington, D.C.
Author: Ellen J. Silverman
Date: Wednesday, May 24, 2006

The US economy is set to grow by a robust 3.6 percent in 2006, but the Federal Reserve should increase interest rates, the Organization for Economic Cooperation and Development (OECD) said while warning strongly about high deficits, deep trade imbalances and low savings.

The American economy weathered Hurricane Katrina and has absorbed oil price shocks but is now at risk of overheating, the OECD stated in its twice-yearly review of the world economy this week. "Monetary policy, currently near neutral, needs to tighten slightly to keep the economy in balance," the OECD said. The report described current account imbalances in the US which the OECD predicted could reach 7.5 percent of GDP in 2007 -- as "unsustainable", adding that "most observers agree that ... a rebalancing looks increasingly unavoidable".

Such a correction could entail a further depreciation of the already weakened dollar, possibly to the extent of one third to one half, the report said, citing estimates by non-OECD experts. Short-term interest rate for 2006 would settle at 5.1, remaining steady in 2007. The current fed funds rate is 5.0.

The projection for the US economy's real GDP growth in 2006 was 3.6 percent, up from its forecast six months ago of 3.5 percent. Growth in 2007 should taper off to 3.1 percent, the report says. The OECD forecasts were based on oil prices stabilizing around 70 dollars per barrel. The OECD said of the US economy that "profitability is high, business confidence is strong and job creation robust", adding that unemployment had come down to near structural levels. But it also noted that real growth had lagged behind productivity. The vast majority of wage earners have seen their purchasing power actually decline, with most gains in wealth coming from the housing and stock market.

Despite a substantial boost from soaring energy prices inflation has remained flat in the US, but the OECD cautioned against the possibility of "imported inflation". The integration of low-cost manufacturing nations into the world economy had helped keep prices down by giving consumers in the US access to cheap goods. At the same time, however, China, India and other developing nations growing at double-digit rates had brought about "a prolonged upward trend" in oil and commodity prices, creating inflationary pressure. For economies close to full employment, such as the US, this "possibility of prolonged imported inflation coupled with an upward drift in inflation expectations, may tilt the balance toward further tightening".

The OECD reserved its strongest comments for the US's soaring current accounts deficit, a broad measure of trade in goods and services along with certain financial transfers. The widening of the US deficit which went from 3.8 percent of GDP in 2001 to nearly 6.5 percent in 2006 and may rise to 7.5 percent in 2007 was caused by increased energy prices, huge foreign exchange reserves in China and Japan and low savings rates in the US. "A brutal unfolding of these imbalances would hurt the world economy," the OECD noted, saying that a correction of the US current accounts deficit could be "orderly and gradual. But the risk remains of an abrupt and costly unwinding remains," it added.