The Three Bears
Our best judgment for the economy’s performance over the next year is popularity known as the Goldilocks scenario: not too hot, not too cold, but just right. In this central banker’s paradise, idle resources are at a minimum and inflation is generally tame. As with the fable’s heroine, however, the economy will contend with a few “bears” – or downside risks.
One such risk comes from the single-family housing market, where building activity remains buoyant despite declining sales since the middle of 2005. A consequence of this mismatch is record levels of unsold properties that are causing prices to weaken. As of March, for example, the median sales price for a new home was down 2 percent from a year-ago.
According to the National Association of Homebuilders, developers are starting to catch on. Last summer, 80 percent expected (incorrectly) that sales would improve over the next six months, whereas that same figure sank to 58 percent by April. Still, their optimism seems excessive and, unless homebuilders quickly retrench, a more serious overhang may emerge.
The second risk is familiar to anyone who drives rising energy prices. These have weighed heavily on consumers for the three years now, though their effect has been hidden by tax cuts and the housing boom. But with these offsets no longer in force, and no obvious candidate to take their place, further energy price hikes will become increasingly relevant.
What makes this risk so troubling is its basis, more in geopolitics than economics. While it’s true that demand for oil has surged in recent years, it’s incomprehensible that the marginal cost of extracting a barrel has doubled over that time. Yet with the “call on OPEC” (essentially the spare capacity that could rapidly be brought to market) now running at one-third of its historic norm, any perceived threat to supplies immediately translates into higher prices. And with so many potential problems afoot (Iran, Iraq, Cameroon, Nigeria, and Venezuela, to name but a few), further price spikes cannot be ruled out.
Our third bear goes by the name of “abrupt balance of payments adjustment.” Simply put, our nation’s large current account deficit and low savings rate leaves us highly dependent on foreign capital, which has been eagerly forthcoming in recent years. Explanations for these heavy capital flows include “excess” savings abroad and foreign government efforts to depress their exchange rates. In either instance, however, the flows are not assured. And with growth abroad now improving, domestic investment options for their savings are expanding while their reliance on export-driven economic growth will diminish. If this adjustment unfolds gradually, as has been the case so far, the risks are slight. But a sudden adjustment would drive the dollar abruptly down and interest rates upward as foreign interest waned.
Finally, it’s important to recognize that these risks are not mutually exclusive. Diminished foreign capital flows amidst higher energy prices and softening housing markets would make for a terrible interaction. But as I recall, Goldilocks eluded the bears and lived happily ever after.
