COUNTRY BRIEFING - FROM THE ECONOMIST INTELLIGENCE UNIT

The outlook for the US economy may be dimming. Inflation is rising, housing is slowing, the dollar has been falling and the Federal Reserve may have to raise interest rates more than it once thought. Although most analysts, including those at the Economist Intelligence Unit, expect the economy to slow later in the year, the ride could be bumpier than anyone imagined.

Fed Chairman Ben Bernanke says he is watching the data closely to gauge the economy’s health. He can’t be pleased with what he has seen this week. Inflation rose 0.6% in April from the prior month, the most since January. Amid soaring oil prices, this is not especially alarming. More worrying, core prices, which exclude volatile fuel and energy, also rose more than forecast and jumped 2.3% on a 12-month basis, the most in 13 months. Traders in interest-rate futures quickly raised their bets for another Fed rate increase in June to 50% from around 40%. European inflation figures were also above forecast, leading to a sell-off in equity markets May 17th on both sides of the Atlantic.

Not much slack

The US inflation scare is being pushed in part by an economy that is still growing rapidly, consuming whatever slack may have remained. Industrial production in April rose by the most since December and at twice the monthly average of the past year. Factories are running all out, operating at 81.9% of capacity in April, the highest in six years. At the depth of the recession in 2001, many economists assumed capacity utilisation wouldn’t rise back to its long-term average as manufacturing shifted overseas. But factory use is now above its 20-year average of 80.9%.

Strong production growth is, of course, good news for US manufacturers and suggests companies are buying more equipment—a sign of rising business investment. But if factories become overstretched, prices will rise as companies find it easier to pass on cost increases.

For the Fed, managing inflation expectations is as important as quelling inflation itself. The mere risk of rising inflation will lead investors, companies and workers to factor price rises into their cost calculations, making faster inflation a self-fulfilling prophecy. This is already happening, at least in financial markets: the gap in yield between inflation-protected US Treasury notes and regular 10-year securities rose 0.04 percentage points after the inflation announcement, a relatively big move. The spread has jumped to 2.71% from 2.34% at the start of the year.

Falling dollar

The drop in the dollar during the last two months will only make inflation worse. The greenback has fallen 7.4% this year against the euro and 5.9% against the yen. That will raise the cost of imports, a serious concern in a country that ran a $726 billion trade deficit last year. Already import prices are rising, jumping in April by the most in seven months. The dollar may have further to fall. Growth is picking up in Europe, and the return on euro-denominated assets may climb. Certainly, European and Asian stock markets are outperforming those in the US. And the interest-rate gap between the US and Europe may start to narrow, since the European Central Bank seems near the start of a rate-rising cycle and the Fed is closer to the end.

But is the Fed, indeed, about to end its streak of rate hikes? The Economist Intelligence Unit has been forecasting a federal funds target rate of around 5-5.25% for most of the last two years. With the rate currently at 5%, we had been expecting another increase in June and then, perhaps, a pause if the predicted slowdown in the economy materialized. That remains our forecast, although the risk of further rate increases is climbing.

Asleep at the wheel?

Mr Bernanke has suggested he may want to stop increasing rates, at least temporarily, to measure the effects of the 16 prior moves, which took the Fed’s main rate to 5% from 1%. That’s sensible, since monetary policy works with a lag, but he may not have that luxury. Mr Bernanke is still new in the job and largely untested. If inflation, and inflation expectations, are rising, he will have little choice but to keep pushing rates higher. If he doesn’t, inflation may rise all the faster as the markets assume the Fed is asleep at the wheel.

What does all this mean for the health of the US economy? The Economist Intelligence Unit is expecting the string of rate increases to curb consumer spending, and that looks even more likely if borrowing costs keep rising. Cautious consumer spending will be amplified by a slowdown in the property market—housing starts in April were at a 17-month low—and less borrowing by homeowners against the value of their houses. This may lead to a rougher ride in the coming months than most Wall Street economists expect. The median forecast of 81 economists surveyed by Bloomberg News is for fourth-quarter growth of 3%. That’s too high, in our view. We expect growth of around 1.9% in the final three months of the year, down from 4.8% in the first quarter.

That doesn’t mean the economy is in serious trouble. Job growth has been good, wages are rising and businesses are investing more, all encouraging signs. But the renewed threat of inflation has made Mr Bernanke’s task of gently slowing the economy look much harder.