2005, Part II

With all the economic news coming out lately, it’s easy to forget how well the U.S. economy has been performing. Headlines in 2005 have worried over oil prices, interest rates, pension problems, and Social Security reform, while strong growth and low unemployment and inflation have gone largely unheralded.

It’s the nature of news to focus on uncertainty, so the steady drumbeat of downbeat headlines is probably not much different from what we’ve seen in years past. Nonetheless, as you review your personal financial outlook, it can be useful to remind yourself of both the positive and negative aspects of the U.S. economy.

Interest Rates and Inflation

The Federal Reserve began an interest rate–tightening campaign in June 2004 that some experts believe may be winding down soon. The Fed promised and then delivered a series of “measured” increases in key short-term interest-rate targets intended to help stave off inflation — often a by-product of economic growth. And inflation has been fairly well under control. As of May 2005, the Consumer Price Index has been growing at less than 3% over the past year, despite the run-up in oil prices.¹

The 200% increase in the federal funds rate between June 2004 and May 2005 has had a predictable effect on short-term interest rates, but long-term rates have reacted differently. Between May 2004 and May 2005, the yield on the 10-year Treasury bond actually fell from 4.7% to about 4.1%.² This is a somewhat puzzling development but it seems to indicate that lenders are indifferent to the amount of time they tie up their money because they don’t see interest rates changing significantly anytime soon.

Oil and Economic Growth

The recent spike in oil prices has been blamed on a range of factors: concern over supply disruptions in the Middle East, limited U.S. refinery capacity, and rapidly growing consumption by China and India. Oil is essential to economic growth in the United States, and changes in the price can have an exponential effect on the economy.

Yet oil prices have not always kept pace with inflation, and in real terms, today’s prices are only modestly higher than two decades ago. For example, the average price for a barrel of oil rose from $21.75 in 1986 to $50.51 as of May 31, 2005. When you adjust the 2005 price for inflation, the cost has risen to only $28.68 per barrel.³ This may help explain why overall inflation has remained low while oil prices have skyrocketed.

The rising price of oil has also apparently done little to dampen growth in gross domestic product (GDP), the value of all goods and services produced in the United States. Although advance GDP estimates put first-quarter growth at 3.1%, — which was widely characterized in the news as an economic slowdown — revised numbers show growth was a relatively strong 3.8%. This is lower than the 4.5% GDP growth in the first quarter of 2004, but still solidly within the range that most economists consider healthy for the U.S. economy.⁴

If oil prices continue to rise significantly, it would be difficult to imagine that the world economy wouldn’t react eventually.

Employment and Earnings

The nation’s employment situation has been quietly improving. The unemployment rate in May 2005 was 5.1%, the lowest since September 2001 and much lower than the 6.1% rate of May 2003.⁵ At the same time, wage and salary income has grown at a 10% annual rate.⁶ These two factors bode well for the economy. Businesses apparently are confident enough to add jobs, which may suggest there is growing competition for good workers.

It’s easy to focus on the weak spots in the economy because that’s what we hear about the most. But also keep in mind the many strong undercurrents. Please call if you would like to know more about how current economic conditions may affect your financial situation.

1, 5) Bureau of Labor Statistics, 2005
2) Federal Reserve, 2005
3) U.S. Department of Energy, 2005; Consumer Price Index through May 2005
4) Bureau of Economic Analysis, 2005
6) The Wall Street Journal, June 28, 2005

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