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Weekly Economic and Financial Commentary

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The Changing Mix Of Growth Will Help Tame Inflation

Mon, Sep 8 2008, 06:17 GMT
by Wachovia Research Team

Wachovia

U.S. Review

Even Weaker Than The Headlines

The stronger-than-expected upward revision to second quarter real GDP and better than expected news on factory orders had briefly bolstered optimism about near-term economic prospects. That optimism was dashed this week, however, as jobless claims and the unemployment rate both came in much worse than expected. Monthly chain store and motor vehicle sales also remain exceptionally weak. Conditions feel very recession-like, even though year-to-year real GDP growth remains around 2 percent.

The GDP figures give a deceivingly healthy view of overall economic conditions. Most of last year’s growth, and practically all the growth in the second quarter, came from a narrowing in the trade deficit. Exports surged while imports declined. Moreover, while the strength in the economy is narrowly based, the weakness is very broadly based. Domestic demand, which encompasses everything but exports, remains very weak. Gross domestic purchases rose at a paltry 0.2 percent pace in the second quarter and are up 0.4 percent year-to-year.

The Changing Mix Of Growth Will Help Tame Inflation

The changing mix of growth is clearly having a much greater impact on the labor market than it is on GDP. Nonfarm employment has fallen for eight consecutive months, producing a net loss of 605,000 jobs. During this period, the unemployment rate has risen 1.2 percentage points to 6.1 percent.

One reason surging exports have not produced greater benefits to the labor market is that exports still encompass a relatively small proportion of overall growth, accounting for just 13.2 percent of GDP. Moreover, a large proportion of U.S. exports tend to be capital intensive, including such items as power generation equipment, commercial airliners, pharmaceuticals, and medical imaging equipment. As a result, the growth in exports provides relatively little net benefit to the employment figures. The weakness in domestic demand, on the other hand, is much more broadly based and tends to impact labor-intensive industries such as construction, retail trade, and financial services.

The changing mix of economic growth has several implications for the overall economy. For starters, income growth is holding up better than widely thought. While capital-intensive industries employ a relatively small number of workers relative to the value of their output, those jobs tend to pay very well. In contrast, many jobs in labor-intensive fields, particularly retailing, which has lost 216,100 jobs over the past year, and temporary staffing, which has lost 234,500 jobs, tend to have relatively low wages. Along these lines, the changing mix of economic growth has tended to boost productivity and should help contain inflation. Nonfarm productivity grew at an upwardly-revised 4.3 percent pace in the second quarter and is up 3.4 percent over the past year.

While stronger productivity growth may be a silver lining, it does come at a significant cost. The unemployment rate has risen sharply in recent months, including a 0.5 point jump in May and a 0.4 jump in August. One month jumps of 0.4 or more in the jobless rate are relatively rare, having occurred just 18 times in the past 48 years. The most recent spikes may overstate the extent of the deterioration in the labor market. The May increase was mostly teenagers, which likely reflects the higher minimum wage as well as increased labor force participation by teenagers, whose interest in work may have been piqued by higher gasoline prices. This past month’s jump looks like it is tied to the extension of unemployment insurance benefits, which is causing some job-seekers to extend their job search and others to remain in the labor force in name only.

Global Review

Bank of Canada On Hold

Earlier this week the Bank of Canada (BoC) announced it would maintain the current target for the overnight rate at 3.00 percent, as was widely expected. Like many central bankers, BoC Governor Mark Carney faces the difficult situation of a weakening economy and an environment of rising inflation. Canadian Real GDP declined for the first time in five years in Q1, and grew at a less-than expected 0.3 percent annual pace in Q2. Although the overall rate of CPI inflation recently crossed above the top end of the Bank of Canada’s target range of 1-3 percent, the core rate of inflation is well within the range. We expect the Bank will remain on hold through the first half of 2009 as it assesses the outlook for growth and inflation.

In its official statement, the BoC expressed the ongoing challenges to economic growth in the months ahead were developing as expected.

Slowdown in U.S. Economy a Negative For Canadian Exports

Certainly among the most pressing of these challenges is the slowing of the U.S. economy, because 80 percent of Canadian exports are destined for the United States. Exports sliced 2.3 percentage points from second quarter real GDP growth - the largest negative contribution of any component. Any further slowing of economic growth in the United States would present even greater challenges to exports in Canada.

While acknowledging some deterioration in domestic demand, the Bank said that demand within Canada “remains strong” and “still close to the economy’s production capacity.”

The final concern expressed by the BoC was one that should sound familiar in just about any economy around the world these days: global inflationary pressures. With oil down more than 25 percent, and other commodities down from their summer highs, these pressures have been alleviated to some extent. This has offsetting effects for Canada, however. Cooling commodity prices translates into a decline in the value of the Canadian dollar relative to the U.S. dollar. On the other hand, as the overall inflation rate comes back in line within the 1-3 percent target range, the Bank has the flexibility to ease lending rates without fear of engendering inflation. For now it appears economic growth is slowing in many foreign economies and the Bank concludes that “the weaker global growth and the decline of the Canadian dollar will have opposing effects on the demand for Canadian goods and services.”

After two consecutive monthly declines in Canadian employment, jobs increased by a more-than-expected 15.2K in August as the unemployment rate stayed constant at 6.2 percent. The positive payroll growth in August is a welcome turnaround after fairly substantial job losses in July. While the Canadian labor market certainly has its challenges, it is not struggling like its neighbor to the south. The U.S. unemployment rate has risen by 1.7 percentage points since March 2007, while Canadian unemployment increased by only 0.3 percentage points since its cycle low in February of this year. Relatively solid employment growth in Canada should continue to support consumer spending in the third quarter. Indeed, real consumer spending was up 4.3 percent on a year-over-year basis in the second quarter.

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Published on  Mon, Sep 8 2008, 06:23 GMT