The U.S. economy is growing at a rate that is above trend and will continue to do so for some time, according to Dr. Martin Feldstein, president and CEO of the National Bureau of Economic Research.
Feldstein, who is regarded as a possible successor to Alan Greenspan when the chairman of the Federal Reserve Board retires next year, spoke at WesCorp's Future Forum conference here. He said the U.S. GDP (gross domestic product) growth rate of 4.4% in 2004 was "strong, but unsustainable."
"A weakness in exports pulled the actual number down to 3.5%, which is the rate I expect in 2005," said Feldstein, who added GDP growth has averaged 3.3% for the past 10 years.
Not surprisingly, interest rates were a frequent topic of discussion at the Future Forum -especially the shrinking spread between short- and long-term rates. With the core consumer price index (CPI) up 2.6% in the first quarter of 2005, the Federal Reserve will continue to raise short-term interest rates "at a rate and to a level the equity markets will not like," according to Feldstein.
"Key drivers of future inflation point to an increase in inflation unless the Federal Reserve acts. We are seeing stronger and faster increases in compensation, which translates into higher prices for products," he said. "The 10-year and mortgage rates have been unusually low, but if the Federal Funds rate goes to 4% or 4.5%, I would not be surprised if the 10-year rate goes to 5 or 5.5% in the next 18 months."
"There is no question the Federal Funds interest rate will continue to rise," he continued. "No one is sure how far it will go, what a neutral rate is, and if the Fed will stop at a neutral rate. The Fed is comfortable with an inflation rate of about 2%, so it probably will have to raise rates to keep inflation down."
The United States has a large trade deficit with the rest of the world-5.7% of GDP. Feldstein said a trade, or account deficit of 4% usually presages a significant decline in the value of a nation's currency. However, because the U.S. borrows in its own currency-the dollar is reserve currency for most central banks-it can "enjoy" ("if that's the right word," he quipped) a larger trade deficit than other countries.
Feldstein emphasized he is not predicting a currency crisis, but said the U.S. must attract more foreign investment. The investments coming in are fixed investments, which tend to be from governments, not private investors, he explained.
"My two predictions are: we will see a correction in the current account deficit, and a reduction in the value of the dollar, and we will see an increase in savings or reduction in investments by the American public."
This is important, Feldstein asserted, because the U.S. savings rate is close to 0% of GDP. This is due to three factors: the stock market tripling in the last 10 years, a dramatic increase in real estate values which has given people the impression they don't have to save, and declining interest rates.
"None of these three things will happen in the next 10 years, so I'm convinced the savings rate will increase."
Feldstein said there are, as usual, risks ahead for the economy, though he said he was not predicting any of these events. In addition to the ever-present possibility of a sharp increase in oil prices if something goes wrong in the Middle East, he identified three possible scenarios that would have a significant negative effect:
* A destabilizing correction in the current account deficit, which could lead to a significant increase in long-term interest rates.
* A sharp change in housing prices that slows household spending.
* A problem with credit derivatives, which Feldstein said have been used as speculative investments. He said the behavior of hedge funds in recent years has led to "heavily leveraged" investments.
