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U.S. Economy Moving Toward Full Employment, According to Harris Economist

CHICAGO, October 21, 2004 – The U.S. recovery train remains on track toward its destination of full employment, despite losing some steam amid rising energy costs, according to the new Outlook 2005 report presented today by Harris Bank's Chief Economist. After expanding at an outsized 4.4 percent in 2003 on a fourth-quarter-over-fourth-quarter basis, the economy appears to be chugging along at a 3.9 percent clip this year.

"Though moderating from last year's rapid pace, growth has been high enough to gradually reduce the jobless rate even in the face of phenomenal productivity gains," said Tim O'Neill, Chief Economist, Harris Bank. "Growth is poised to moderate somewhat in 2005, though remain above potential."

Continued above-potential growth should allow the unemployment rate to drift down from an expected 5.4 percent in the fourth quarter of 2004 to 5.1 percent by the end of 2005 and to 5.0 percent by late 2006. This means the economy will be operating at "full employment" – the jobless rate associated with stable inflation pressures in the long run – in about two years time.

After moving above US$55 per barrel in October – up from $32 a year ago – crude oil prices are projected to retrace to about $33 by late 2005. Nonetheless, given both the short-term and long-term effects of rising prices on demand, the run-up in energy cos ts will likely subtract one-half of a percentage point from growth in the second half of 2004 and the first half of 2005. "By the second half of 2005, falling oil prices should start to support growth," predicted Dr. O'Neill.

Provided that growth remains at or above potential, the Federal Reserve is expected to continue lifting rates in bite-sized steps at each of the next four policy meetings through March 2005. "By then, with a full 175 basis points of tightening under its belt, policymakers will likely sit back to assess the impact of their actions on the economy," predicted Dr. O'Neill. "But by the fall of 2005, the Fed should resume its tightening cycle, slowly guiding the federal funds rate to a more neutral level of 4.5 percent by the fall of 2006."

U.S. Election
Dr. O'Neill also noted that while the upcoming U.S. presidential election won't have a dramatic impact on the economy, either winner will have to minimize expenditure growth and find new revenue from some sort of tax increase.

"No matter who wins, the challenges will be the same and the economic policy responses broadly similar," stated Dr. O'Neill. "Both President George Bush and Sen. John Kerry would have to continue to make major expenditures on security and on the military activities in Iraq and Afghanistan. They are also both promising new spending in health care. All this is going on with looming contingent liabilities in Social Security and Medicare. And with the deficit as large as it is, they won't be able to rely on economic growth alone to deal with it."

World Outlook
World growth will likely be near 5 percent this year, largely because of the broad-based monetary easing that took place in response to the global slowdown of 2001-02. The strength in the Chinese economy has also been a key factor in sending growth higher in neighboring economies, particularly Japan. With the expansion on solid footing, most central banks have begun to raise interest r ates, normalizing the extraordinarily easy monetary conditions in place.

"Higher interest rates will dampen economic growth in 2005 as will the sharp rise in oil prices this year," predicted Dr. O'Neill. "Nevertheless, though slowing, world growth is still expected to be above 4 percent in 2005."

Euro zone
Economic growth in the Euro zone picked up in the first half of 2004 rising an annualized 2.2 percent – double the rate in the second half of 2003 and a marked improvement over the decline in the first half of 2003. External demand has been the driving force of growth this year as net exports accounted for 60 percent of GDP growth in the first half of the year. Slower growth of 1.8 percent is expected in 2005 as global activity, and thus exports, lose speed at a time when domestic demand is still struggling to gain momentum.

"At this pace there is no urgency for monetary tightening as below-potential growth should ensure excess capacity and low inflation," said Dr. O'Neill. The European Central Bank is not expected to raise rates until early- to mid-2005.

United Kingdom
The U.K. economy is in good shape. Growth is well above trend, unemployment is the lowest in decades and inflation below target. To ensure inflation stays low, the Bank of England started tightening monetary policy almost a year ago. Since November 2003, interest rates have been raised 125 basis points. Further tightening is expected to take the repo rate back to a neutral 5.25 percent by early 2005.

"Higher interest rates are expected to slow the economy in the latter half of 2004 and into 2005," predicted Dr. O'Neill. "Nevertheless, in 2005, the economy will still be growing above potential.

Japan
The current Japanese expansion is more than two years old and has proved surprisingly strong. "Growth will likely average above 4 percent in 2004 – the most rapid since 1990," said Dr. O'Neill.

Successful industrial res tructuring has been the key to the durability of this recovery. Since the late 1990s, companies have reduced costs, cut excess capacity and lowered corporate debt. While restructuring has fueled strong profit and productivity growth, it has also dramatically cut employment and wage growth and, consequently, consumer spending.

Looking forward, the upward trend in Japan's exports is likely to continue on the back of still firm, albeit slower, global growth, especially in the U.S. and China. And, as long as exports are rising, a mild recovery in domestic demand should continue. But despite the favorable cyclical developments, long-run obstacles to growth remain. Japan's financial system is still weak, with bank lending continuing to decline and fiscal finances dire. "The need for fiscal tightening will restrain economic activity in Japan for many years," concluded Dr. O'Neill.

Emerging Asia
Economic growth in Emerging Asia has now reached a cyclical peak and should see a gradual slowing through 2005. "Slower growth in the main developed economies combined with China's efforts to moderate its lofty expansion will dampen the region's fast-paced export activity," suggested Dr. O'Neill. "High oil prices will also have an adverse impact on those Asian economies which are dependent on energy imports." Overall regional growth should moderate to 6.7 percent next year after averaging just under 8 percent in 2004.

Latin America
This year, Latin America is undergoing a robust recovery, with GDP expected to rise more than 5 percent – the best result since 1997. "The region has been helped by external developments, including higher commodity prices, healthy U.S. and Chinese markets and low international interest rates," said Dr. O'Neill. Regional growth should subside as these advantages wane in 2005 and as economic policies are tightened in response to emergent inflation pressures.

The full Outlook 2005 report is availabl e at www.bmo.com/economic .