Federal Reserve May Tighten Rates To Offset Weak Economy Says Conference Board

Business investment has been one of the few bright spots in the U.S. economy. The key to improved U.S. economic performance in 2006 will be the continued strength of the capital goods sector, says the Conference Board. Fed may raise rates to sustain profit growth.

From The Conference Board

The key to improved U.S. economic performance in 2006 will be the continued strength of the capital goods sector, according to an analysis released today by The Conference Board, the global research and business membership organization.

Business investment has been one of the few bright spots in the U.S. economy. Nondefense capital goods orders surged at the end of 2005 on the back of a doubling of aircraft orders in the fourth quarter of last year. The slow economic recovery and the rapid deterioration in consumers' income have helped hold down the recovery in consumer spending from the low point in 2001 and 2002. The big question is how long U.S. growth can be sustained with a gradually deteriorating consumer sector.

"The volatile capital goods sector can distort the strength of short-term economic trends, which, when defense purchases are included, are stable, if not slightly deteriorating," says Gail D. Fosler, Executive Vice President and Chief Economist of The Conference Board. Her analysis appears in StraightTalk, a newsletter designed exclusively for members of The Conference Board's global business network. "Even more worrying is the growing gap between new orders of consumer goods and activity in the investment sectors."

Profits Under Pressure

Fosler says it will be very hard to sustain recent profit gains in this weakening economic environment. The Conference Board economic growth forecast for this year has increased slightly to 2.9%, while the year-on-year growth comparison is down to 2.5% by the fourth quarter of 2006.

"The Federal Reserve may be tempted to tighten rates excessively at a time when the growth signals are at best mixed and, more disquieting, when the prospective trends may be down," says Fosler. "Persistence in raising rates invites a sharp change in sentiment toward caution that will reduce long-term yields and significantly invert the yield curve."

The nondefense capital goods sector has dominated the consumer goods sector since early 2004, consistent with the peak in consumer income gains. The widening difference in relative performance between these two sectors has been sustained longer than at any time since the gap between 1987 and 1989. The capital goods environment is driven by extraordinary corporate profitability and cash flow (the flip side to the weakness in consumer income gains) as well as global market dynamics.

Asian Economies Are Still Growing

The clear center of global growth is Asia, where most economies are still growing rapidly. But growth rates are easing.

Asia is increasingly depending on trade within the region. Since 2003, inter-Asian trade has doubled, while Asian trade with both the U.S. and the European Union is up only about 50%. This reflects a large shift in the relative importance of markets to Asian producers. Since 1999, for example, the share of Asian exports that go to the U.S. has dropped from 23% of total exports to 18%, while the share to the EU is down from 17% to 15% in 2005.

Fosler notes that the acceleration in trade within the region is due to relatively faster regional growth rates, as well as an increase in the importance of China. The share of Asian exports to China has almost doubled from about 8% to 15%. The share of exports to other Asian countries is either flat or down. In the case of Japan, they are down substantially-from 11% to 9%.

"Some of these changes, as is likely the case for Japan, are due to the cyclical effects of growth differences," says Fosler. "Others appear to be real structural shifts, such as the relative shift of exports to China and away from the U.S. and Europe. All in all, it does appear that there is some recycling of trade to the U.S. and Europe through China that would have formally come from other Asian economies. On balance, however, Asian economies are less exposed to a slowdown in the U.S. and more exposed to slower growth in China."

These shifts in the locus of Asian trade have occurred primarily during a period of extraordinary Chinese growth that is reflected in a surge in Chinese imports. Between 2002 and 2003, the growth in Chinese imports rose from a 3% annual rate to over a 40% annual rate. But Chinese import growth slowed sharply in late 2004 and 2005, indicating that China may be starting to lose its appetite for foreign goods. Fosler says that the China market is a much less dynamic driver of growth today than it was a few years ago.

Source: StraightTalk, Volume 17, No. 2, The Conference Board

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