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US Treasury Secretary Snow has described the US economy as being in a sweet spot, but there will be increased fears that conditions are now souring rapidly with evidence of slower growth and rising inflation.

If the combination of weaker demand and price pressures continues, the Federal Reserve will face a very difficult task over the second half of the year and confidence in the US economy is likely to falter. One symptom of this would likely to be renewed dollar weakness. The Fed could look to stop rate increases and even cut rates to support the economy, but a lack of overseas confidence could push long-term yields higher.

Given the domestic structural weaknesses and high debt levels, the US economy will be vulnerable to external shocks and high oil prices will be damaging. So far, the indicators are pointing to a measured slowdown in growth rather than a collapse in demand and the Fed is still in a position to maintain control. The possibility of recession late this year should, however, certainly not be discounted.

The latest economic data has raised uncertainty whether the US economy is facing rising inflationary pressure, a slowdown in growth, or a combination of both.

The recent US growth data has been generally disappointing. Retail sales growth, for example, was subdued in March with a headline 0.3% increase and the slowest underlying increase for 12 months while the last employment report was also disappointing, although weekly jobless claims data have not shown a significant deterioration. There was also a sharp 17.6% drop in housing starts for March. The decline in housing activity was likely to have been partly weather-related after the strong figures for February and housing activity is still strong in historic terms.

The ISM indices released at the beginning of April remained generally strong, but there was a sharp decline in the New York manufacturing index for April. Fed Governor Yellen also warned this week that the economy suffered a soft patch during March. Concerns over the economy will increase if there is also a slowdown in the other manufacturing indices over the next two weeks.

Main attention is likely to focus on the consumer and there will be concerns that high energy prices will sap spending. The latest figures on real earnings recorded a 0.3% decline for March, with a 0.5% annual decline. A sustained decline in earnings growth would make it extremely difficult for consumers to increase spending, especially as savings rates are already very low. Consumer confidence will be damaged further if there is a sustained decline in equity prices.

The inflation indices for March recorded significant increases. There was a 0.7% rise in producer prices in March, although the underlying increase was held to 0.1%. The headline increase for consumer prices was also stronger than expected at +0.6% and the underlying increase of 0.4% for the month was double market expectations. There was a clear influence from rising energy costs in the data with transport prices rising strongly, but there were also wider signs of inflationary pressure with clothing costs, for example, rising strongly. The increase may have been affected by faulty seasonal adjustments, but inflation concerns will persist. In the latest Fed Beige Book, the Fed reported an increase in inflationary pressure and evidence of increased pricing power.

US Treasury yields have fallen back to near 4.20% after the subdued economic data from highs beyond 4.50% last month even though inflation concerns have increased. Although yields rose after the US CPI report, there was a swift reversal. Volatility has remained high and the bond markets have struggled to find decisive direction, but the evidence of falling yields suggests that there is now greater concern over a slowdown in growth.

The combination of rising costs and weaker demand have also been seen in sectors such as the car industry with a huge losses posted by General Motors and Ford. Although car demand has eased slightly, the main pressures on profitability have come from rising costs due in part to higher medical insurance and pension costs. There will be concerns that the symptoms seen within the car industry will spread to the economy as a whole. If there are sustained cost increases and pressures on profitability, there will also be a risk that the corporate sector will not be able to maintain investment levels.

It would be a mistake to attach too much credence to recent data, but there will be increasing fears that the US economy will slow sharply at the same time as inflation rises. This pattern of events followed the oil crises of the 1970’s and to a lesser extent the trends were also seen at the time of the first Iraq war in 1991. Oil prices are still above the US$50 p/b level and if the growth data remains disappointing over the next few weeks, there will be fears of a repeat for this economic cycle.

The US vulnerabilities will be increased by the fact that the US consumer and government sectors have little scope to support demand. Consumer balance sheets are already stretched and savings rates are low. Given these stresses, consumers will be looking to rebuild savings rather than increase spending. With the government budget deficit likely to be over US$400bn in the latest fiscal year, there is also very little scope for an expansion of fiscal policy.

The US Federal Reserve will face difficult decisions if there is a combination of rising inflation and weakening growth. The difficulties will be increased by the US Fed’s mandate. The Bank of England and ECB, for example, have specific inflation forecast to meet and this makes the task slightly easier as they do not have responsibility for supporting growth. The Fed’s mandate is, however, wider as there is also the need to support employment. In this context, there will be greater risks that the Fed will slow or stop monetary tightening if growth starts to slow. There will also be greater discussion over an inflation target over the next few months, particularly with Fed Chairman Greenspan’s term of office ending early next year.