Major Forces Shaping the U.S. Economy Essay

Three issues will shape the economy’s performance the next 18 months. To what extent will consumer spending slow? What is the outlook for business expenditures? Will the Federal Reserve go too far in raising rates? Commentators and pundits are prone to say that consumers are â€Å"in great shape,† |†still going strong,† â€Å"resilient,† and so on. While it is easy to get caught up in this optimism, there is a need to focus more on the finances that underlie this spending. On a basic analysis, it will quickly become apparent that household finances are stretched to the point where slowdown can be expected, perhaps a significant slowdown, in consumer spending the next 6-12 months. Some of the reasons behind such a possibility are: Interest Rates: With the overall cost of credit rising since 2004, Americans with large outstanding balances on their credit cards, home equity loans, and adjustable rate mortgages are starting to feel the pinch. The Explosion in Household Debt. For years, Americans have been spending far more than what they have been earning. With borrowing costs historically low and home equity values increasing, consumers piled up on debt to finance a level of consumption that far exceeded their income growth. In the last five years, Americans have increased their total outstanding debt by $5 trillion. (To put that number in context, corporate sector debt jumped by about $1 trillion in that time frame, while federal government debt rose by $1. 3 trillion). That $5 trillion in additional liabilities brought total outstanding household debt to a record $11. 8 trillion. Servicing this massive liability was certainly easier when interest rates were low. But after a steady rally of rising rates, the burden of carrying those IOUs has now gotten much harder. Gasoline Costs. In addition to servicing that huge debt, Americans will need to part with more money for gasoline in coming months. A few other reasons on this line are: Rising Healthcare Costs Marginal Growth in Real Income Tougher Personal Bankruptcy Laws A Boost to Savings because of Rising Interest Rates The cumulative effects of these factors will depress consumer spending the second half of the year and probably through the first half of 2007. What is the Outlook for Business Expenditures: Since consumer outlays make up 70% of all U. S. economic activity, the expected slowdown in household spending will have a palpable impact on the economy. Fortunately, what will keep the economy out of any serious trouble is business spending. Driving capital expenditures this year will be strong profits, high capacity utilization rates, strong foreign demand for U. S. products, global competitive pressures, and that the cost of capital remains relatively low. Will the Federal Reserve Go Too Far in Raising Rates: So long as the Fed does not go too far in raising rates, a level that can be defined as above 5. 50%, the threat of recession is nil this year and next. Led by weaker consumer spending a softer housing market, U. S. economic activity can slow markedly in the second half of 2006 and last through the first half of 2007. However, strong business expenditures and a pick up in exports will keep the economy out of any serious trouble. Of course, should the economy suddenly be sideswiped by a serious external shock, the threat of recession becomes more real. The severity and timing of the downturn will depend on the nature of the shock. While there are numerous risks that bear close watching — such as the war in Iraq, the Israeli-Palestinian talks, North Korea, 2006 hurricane season, Venezuela, Nigeria —the threats that have the greatest probability of materializing involve Iran, a terrorist strike on Saudi oil facilities, and an Avian flu human pandemic (Baumohl).