Higher Interest Rates and Oil Prices are Slowing the Global Economy

We are in one of those odd economic environments where bad news is good news. And, the good news is that rising interest rates and some unexpectedly sharp oil price hikes are putting the brakes on the global economy. The U.S. Commerce Department reported that U.S. retail sales rose in August by only 0.2% (seasonally adjusted), compared to increases of nearly 1% in both June and July. Auto sales dipped in August by 0.4%. The factory and construction sectors have produced the weakest economic reports as orders dropped and inventories rose.

The National Federation of Independent Business reported that its members, mostly small businesses, experienced slower sales, earnings and capital expenditures in August. Even more telling: only 19% of NFIB members reported raising prices over the past three months, the lowest since January. Producer prices fell a seasonally adjusted 0.2% after being flat in July. Much of this was due to sharp drop of 0.7% in food prices and a smaller dip of 0.2% in energy prices. However, higher oil prices are likely to drive both these components higher this fall. Inflation hasn't been whipped, but the cooling economy is giving the Fed more room to adopt a "wait-and-see" stance, possibly to the point of shifting from the "tightening" bias of recent months to a more neutral position.

Goldman Sachs economists Ed McKelvey and Gavin Davies note that the U.S. trends of recent months have also been observed worldwide. In their September Global Economic Commentary they wrote that "it now seems likely that the peak rate of GDP growth occurred during first quarter, 2000, when the OECD economies expanded at a rate of 5.3%. By the 2000 Q2 this growth rate had subsided to around 4% and our latest estimates suggest that it will be around 2.5% in Q3." They go on to note that the slowdown since the end of the first quarter has occurred in "virtually all regions of the world." Oil price hikes and rising interest rates explain most of the slowdown.

Of course, the key question is whether this third quarter slowdown is a pause or a turning point. McKelvey and Davies think the third quarter is abnormally weak and anticipate "a distinct rebound in global growth during the first half of 2001, from 2.6% in the current quarter to about 3.5-4.0% in the first half of 2001." They note that labor productivity is still rising in the U.S. In fact, output per hour in the non-farm sector rose 5.2% between the second quarter, 1999 and the second quarter, 2000, the largest yearly increase in 17 years. Moreover, this occurred in the tightest labor market in 30 years, which normally depresses productivity growth because firms must hire less-skilled workers to fill positions.

Where is their optimistic forecast at risk? Growth could accelerate above forecast, especially if the capital investment boom underway in the U.S. continues to elevate productivity growth. Of course, in that scenario, the economy could accommodate the growth without additional inflationary pressures, essentially the same environment we experienced between 1998 and this year. On the downside, the growth they forecast could put sufficient additional pressure on oil and gas supplies to force up prices and trigger inflation along with the commensurate response from central banks worldwide.