© Copyright 2006 Rogers Publishing Ltd. The following article first appeared in the July 2005 edition of BENEFITS CANADA magazine.
With consumer spending driving it, what does the future hold for the world’s largest economy?
Patricia Croft, Vice-president and chief economist with Phillips, Hager & North Investment
Management in Toronto.

Is the Fed afraid of inflation or even deflation?

PC: I think so: we’ve had an increase in the Fed funds rate from 1% to 3%, but in real terms it’s still pretty close to zero. However, I still think the risks of inflation and deflation are fairly balanced, but the Fed is far more fearful of deflation.

The core rate of inflation doubled from 1.1% to just over 2%, but it’s pretty stagnant right now. However, unit labour costs—the building block of core inflation—show an uptick [which may] portend inflation down the road. It’s not a story for 2005, but potentially more of an issue for 2006.

BC: What might trigger a deflationary environment?
PC: The U.S. is a very highly leveraged economy. I think the deflationary scenario would pan out if longterm rates went up sharply and brought an end to the housing cycle, which would in turn put a real crimp in consumer spending. You’d see an environment of very weak growth and possibly deflation; this tug-of-war between inflation and deflation may be what the bond market has been signaling with the flat yield curve.

BC: Coming out of the recession a few years ago, the U.S. was said to be in a “jobless recovery” period. Is job growth healthy in the U.S.?

PC: I wouldn’t describe it as healthy—it continues to surprise on the downside. Looking at the typical cycle of employment gains in post-recession periods, this is by far the weakest employment recovery that we’ve seen in the U.S., although the unemployment rate is still quite low at 5.1%. Some sectors such as manufacturing have seen a secular decline, while others such as the service sector have been fairly strong. On balance, however, there’s been very weak employment growth.

What’s really driving the U.S. economy is the housing market. Greenspan’s not using the “b” word, but we’ll come right out and say it is a bubble—that represents a risk when consumer spending is 70% of economic activity in the U.S., and 15% of the world economy. Our concern is if housing prices just level off—they don’t even need to fall—that will be a big headwind for consumers.

BC: There were recently negative real savings rates—is there any indication that has changed?

PC: We haven’t seen it yet—there’s no suggestion that they’re going to become like consumers in Europe and Japan. Of course, it may actually be a rational decision: interest rates are extremely low, and savings are being created through home equity. So, even though debt levels are high, net wealth is at a record high as well.

BC: What about the currency outlook?

PC: So far this year the U.S. dollar has actually strengthened on a trade-weighted basis, but part of that is spread-based: the U.S. Federal Reserve is the only central bank that’s really in the process of raising rates. We believe the U.S. dollar is likely to decline quite materially over the next three to five years. To turn around those massive imbalances on the current account deficit will require a pretty big drop in the dollar. Imports are 50% larger than exports, which is an enormous gap, so the U.S. needs to consume less and Europe and Japan need to consume more, and that’s not a short-term adjustment.

James Lewis is a contributing editor of BENEFITS CANADA.

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