Hurricanes won't damper economy

THE UNITED STATES ECONOMY'S broad-based expansion will continue, despite the damage caused by hurricanes Katrina and Rita, according to economist Tim O'Neill.

In analyzing the North American economic outlook at the National Truck Equipment Association's Economic Outlook Conference in Dearborn, Michigan, O'Neill said the effect of the hurricanes would cause the forecasted third-quarter Gross Domestic Product to be revised to 3.5% from 4%, but that the forecasted fourth-quarter GDP of 2.2% likely would approach 3.8% as the reconstruction kicked in.

“If you think about the way macroeconomic forecasts are done, the actual destruction doesn't show up as a negative, but reconstruction shows up as a positive,” said O'Neill, founder of O'Neill Strategic Economics and the first Canadian economist to be elected to the Board of Governors of the Washington-based National Association for Business Economics. “Now, you can debate whether that's right or not. But all you're doing in a macroeconomic outlook is saying, ‘What's being produced this quarter?’

“Destruction of assets which were already counted … that has a devastating impact on the insurance industry and individuals, but in terms of a macroeconomic act, it ends up having, over a three- or four-quarter period, a very small effect. The macroeconomic economy is incredibly resilient. So anytime there's a catastrophe of this sort and someone says, ‘This is going to fundamentally change the way people and industries react,’ you should say, ‘I don't believe it.’ It virtually never happens. It didn't happen after 9/11. It didn't happen after the hurricanes that hit Florida last year. It won't happen this time with Katrina or Rita.

“What we're likely to see is consumer spending slackening off. Interest rates are rising, so that's going to affect real estate, home construction, and a lot of purchases that are associated with that.”

He said the growth rate for both 2005 and 2006 likely will be 3.5%, compared to 4% in 2004.

Steady growth rate

O'Neill said growth has been “remarkably steady” over the past two years. Except for the “strange increase” of 7% in the third quarter of 2003, the growth rate has been between 3% and 4% every quarter.

“The economy has been growing at that pace on a sustained basis over the last couple of years, and I'd anticipate that to continue,” he said. “The composition is important to keep in mind. You have final domestic demand growing at close to 4%. What's been dragging it down are the trade numbers. Exports, certainly during the downturn of '01, '02, and '03, were on the weak side. We also had unreasonably strong currency.”

He said the Fed will continue raising rates, with the US Federal Funds rate going from 1% in 2004 to an expected 4% by next year. Yields on a 10-year government bond are forecast to increase from 4.2% in July to nearly 5.5% by July 2006.

O'Neill said the spread between long and short rates will remain relatively stable.

He said the risk is a trade imbalance that negatively impacts the dollar, possibly causing a 20% decline in 2006.

Another risk is high energy prices, although he said he expects oil prices will track down.

“By the end of '06, we're looking at a price below $45 a barrel,” he said. I think the fundamental demand-supply balance — even when you add China and India from the world demand — is probably something in the mid-$30 range. The question is, ‘How do you get there?’ It's going to be a lot of other oil projects from oil purchasers. Think of tar sands in Canada coming onstream. Think of offshore developments. Think of Russia. That's been the fastest-growing supply over the last decade.”

O'Neill said The Economist magazine continues to forecast a housing-price collapse.

“On the surface, that's a reasonable risk,” he said. “When you have double-digit price increases in a low-inflation environment, clearly that's not sustainable. But mortgage payments as a percentage of income (20%) are on the low side. Look at where they were in the early and late 1980s. The key question is, ‘Is that true for every group?’ Is there a risk here? Of course, there is. Is there a high risk? Is it one where you're going to see an absolute collapse in the housing market? No.”

Mexico and Canada

O'Neill said the Mexican economy likely will moderate over the next 12 to 18 months. After expanding 4.4% in 2004, it will be around 3.5% in 2005 and between 3% and 3.5% in 2006. Trade will continue to be a drag on that growth.

He said inflation will continue to decline from 4% in 2005 to below 4% in 2006, adding that Mexican inflation has been less responsive to the exchange-rate changes.

The bank funding rate will be lowered from 9.75% to below 9% by the end of 2006, with slower growth and declining inflation providing the rationale.

The main forecast risks for Mexico: slowing in the US economy (like Canada, Mexico is heavily dependent on the US market); reversal of the downward trend in inflation (monetary policy credibility rests on continued success in lowering inflation); inadequate growth in credit availability (Mexican banks strengthened by foreign investment but still vulnerable); and reversal in structural reforms (outcome of 2006 presidential election critical to speeding up reforms to improve competitiveness).

His forecast for Canada: domestic demand is strong and growth will improve as the trade sector adjusts to a higher Canadian dollar; consumption is expected to remain solid, though housing will weaken with rising interest rates; business investment will trend higher; net exports will provide less of a drag; and inflation-adjusted house prices have surpassed previous peaks but low mortgage rates are keeping affordability attractive.

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