The US's summer lethargy does not spell doom for the global recovery

The recent hard data for the US confirmed that the economy has been in something of a soft patch. The most recent disappointment was the retail sales data - released earlier this week - that showed a decline of 1.1% m/m, matching a fall last seen in February 2003 on the eve of war in Iraq.

The bad news started with the final reading of Q1-04 GDP, which was revised downward from a good (but far from great) 4.4% SAAR to 3.9% SAAR. June non-farm payrolls printed 112k, less than half what the market expected.

The list goes on: industrial production for June suffered its biggest fall in over a year, and the ISM Manufacturing index - widely seen as the best leading indicator of US growth - hit a nine-month low of 61.1 in June (though 61.1 is still quite high historically).

Is this just a blip, or was the first half of the year the beginning of the end in a remarkable period of US growth? We highlight here three potential culprits for the apparent economic slowdown: high oil prices, the end of the tax rebates, and higher interest rates.

Higher oil prices have had the clearest impact of the three. They have squeezed producer margins, hurt equity markets, and diverted consumer spending to gasoline, denting overall consumer spending and sentiment.

A second factor relates directly to retail sales is the end of tax rebates. Over USD 50bn was returned to households in the opening months of 2004, boosting disposable income and thus spending. With the next round of rebates still months off (if at all), the implications for consumer activity could be serious.

But while tax rebates may be gone, income from other sources has grown, particularly due to rising employment. Indeed, disposable income rose 6.4% y/y in May, up from 6.2% in February - the height of tax rebate season. Payroll taxes are up 6 - 7% y/y, reflecting more people working or higher pay or both. Either way, that is a plus for consumer spending and growth.

The third reason is interest rates. Though the Fed did not raise interest rates until late June, the bond market began to adjust to higher rates in April. That meant higher debt servicing costs for indebted businesses, and greatly reduced incentives for households to refinance mortgages. With interest rates to continue rising, will that act as a drag on future growth?

To a degree, yes. But the Fed's strategy of raising rates at a 'measured' pace is unlikely to cause the sort of pain to curtail business hiring. Nor is it likely to force consumers to put the breaks on their spending. Despite the fact that consumers hold a record amount of debt, much of that is fixed-rate debt at low interest rates.

An environment of gradually rising interest rates reflects solid growth without concerns about inflation. That environment will allow a lengthy period of US growth and that is a supportive environment for emerging markets. So is the current slow patch likely to continue?

We think the answer is no. The mid-year economic lethargy has been due to an unfortunate coincidence of the three factors above. That does not mean the end to strong US growth and thus world growth. Since the beginning of the year at least, we have argued that once the economy has strong momentum behind it (which is does), it does not look back.

We have nudged down our full-year growth forecast to 4.7% SAAR vs. 5.1% previously, but remain happy with our long-held view that the Fed will nudge rates up gradually, with fed funds hitting 2.0% by year-end. That would leave fundamentals, in the form of relatively low interest rates, expansive fiscal policy and now a rapidly expanding workforce, in good shape to prompt future growth.

Douglas Smith, US Chief Economist
Gavin Redknap, International Economist