- The Washington Times - Saturday, January 28, 2006

The Federal Reserve’s job just got a lot more complicated. After 10 consecutive quarters during which the annualized growth rate of the U.S. economy registered at least 3.3 percent and averaged more than 4 percent, the American economy slowed to a crawl during the fourth quarter, as gross domestic product expanded at an annual rate of only 1.1 percent.

The dramatic slowdown came as a surprise to economists, whose consensus projection called for a fourth-quarter growth rate of about 3 percent. Meanwhile, with geopolitical developments in the Middle East (e.g., Hamas and Iran) exerting upward pressure on oil prices in recent days and weeks (crude oil approached $68 a barrel on Friday), the Fed will almost certainly respond to the resulting increase in inflationary pressures by raising its short-term target interest rate another quarter-percentage point at the conclusion of its two-day meeting on Tuesday. Turmoil in the oil market has returned after the Fed had been enjoying some success in preventing earlier soaring energy prices from spilling over into other sectors. The core consumer inflation rate, which excludes energy and food, increased by 2.2 percent during 2005, while the overall consumer price index rose by 3.4 percent.

The deceleration of economic activity during the fourth quarter may have been more pronounced than indicated by the slowdown in the growth rate of GDP, which increased at a 4.1 percent annual rate during the third quarter. As retiring Fed chairman Alan Greenspan has often noted, a better indication of underlying economic activity is final sales, which removes changes in private inventories from GDP. As this page has noted, final sales during the second and third quarters of last year had been galloping along at 5.6 percent and 4.6 percent, respectively. However, because the fourth quarter’s change (an increase) in private inventories exceeded the overall increase in GDP, final sales actually declined during the October-December period by 0.3 percent.

If consumers can somehow re-exert themselves after their fourth-quarter breather (when personal consumption expenditures increased at their slowest pace since the middle of the 2001 recession), then the decline in final sales may be transitory. (With personal outlays exceeding disposable personal income for all of 2005, something that has not happened since 1933 at the depth of the Great Depression, it is, however, difficult to imagine consumers working harder at spending their money than they have been.) Also helpful would be a reinvigoration of business investment spending, which increased at a rate of only 2.8 percent in the fourth quarter after rising by an average of 9.8 percent during the previous six quarters.

If the fourth-quarter slowdown does prove to be transitory, then 2005 will be remembered as the fourth year of an expansion during which the compounded economic growth rate has, so far, averaged 3.2 percent per year. If, however, the economy has entered a period of subpar growth in the face of resurgent oil prices, then the Fed’s job will have become increasingly problematic.

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