Abheek Barua: If the US doesn't slow down next year ...

Some feel that the weak sectors, housing and autos, are too small to have any significant impact on the US economy as a whole.

The question that investors are somewhat desperately seeking an answer to is whether the US economy is likely to decelerate sharply or merely slow down to a gentler pace in 2007. The bond and equity markets are sending conflicting signals. The continuous inversion of the yield curve in the US (where short-term bond yields are trading at much higher levels than long-term yields) suggests that a sharp slowdown is around the corner. Recent academic research endorses this view. US Fed researcher Jonathan Wright ("The Yield Curve and Predicting Recessions, 2006-07"), for instance, claims that if bond yields indeed stay at these levels, the possibility of a recession (simply negative growth) in the next 12 months is a significant 51 per cent.

Equity markets, including Asian markets like India, are less pessimistic. The majority seems to believe in the cliched Goldilocks scenario where US growth in 2007 is "neither too hot, nor too cold". The more forward-looking among them believe that after this mild moderation, the American economy will climb back to its trend levels of over 3 per cent and fall in line with global growth. The US central bank is unlikely to raise interest rates further. If the slowdown is sharper than expected, it might even cut rates to bring the economy back on track.

Current US data remain somewhat mixed. There is a clear recessionary trend in the housing sector and consolidation in the automotive sector. Yet unemployment remains low and things like retail sales continue to be robust. The "Goldilocks-ers" argue that this is pretty much the scenario that will persist for most of 2007. Indicators related to the car and home markets will continue to look weak and perhaps pull some of the aggregate manufacturing sector indicators down. However, broader economic aggregates will continue to look robust.

The crux of their argument rests on the claim that both these sectors""housing and autos""are too small to have any significant impact on the economy as a whole. The automotive sector accounts for just about 1 per cent of US GDP and the construction sector a mere 4 per cent. Services account for more than 70 per cent of US GDP and these show no signs of losing traction. There is absolutely nothing to suggest that even if a manufacturing slowdown were to persist, it would spill over to services. Besides, liquidity is high, credit spreads are low and banks more than willing to lend. That is, there is no sign of a credit crunch that historically precedes a slowdown. Putting all this together, the consensus view is that US growth might go below trend in 2007 but is unlikely to go below 2 per cent. By the end of the year, growth should climb back up to over 3 per cent.

My colleague, Robert Lind, who heads ABN-AMRO's European Economics and Strategy asks a slightly different question but one that is equally important. What if the US does not slow down sharply next year? What does it augur for the future? Assume, he says ("Inconsistencies", ABN-AMRO Research Series, November 2006), that the moderates are correct and the US does avoid a recession in 2007. It simply slows down a tad in 2007 and then from 2008 it falls in step with world GDP growth. Also, assume, for argument's sake, that in this scenario interest rates go up and the dollar depreciates gently (say less than 5 per cent each year).

Rob has a model that builds in the sensitivities of exports and imports to underlying growth. This shows that if indeed the US shows this pattern of growth, its current account deficit moves to a level of anywhere between 10 and 12 per cent of GDP by 2010. This is, however, unsustainable. The global economy, he claims, is unlikely to absorb deficits of this magnitude.

In short, there is a fundamental inconsistency in these projections. These rates of growth cannot sustain simply because the external imbalances associated cannot be funded. Thus, something has to be adjusted to make sure that the external imbalance does not balloon to these levels. This could either be the dollar that depreciates by a massive amount or US growth which decelerates sharply. Or it could be a bit of both. The bottom line is the US economy finds itself in a classic Catch 22 situation. If it manages to avoid a sharp cyclical correction in 2007, it simply exacerbates its structural problems that come back to haunt it in the short run. If the economy does not slow down enough in the next couple of years, the possibility of severe and painful correction going forward simply increases.

The problem, Rob points out, is that the majority of financial investors are refusing to take a hard look at the post-2007 scenario. The economic logic behind the majority of forecasts for the period beyond 2007 is dodgy, to say the least. Analysts expect no major slowdown in the US post 2007 or a major depreciation of the dollar. Yet, most of them assume a sharp contraction in the current account deficit from current levels. It is this fundamental inconsistency of logic, implicit in investment decisions, which bother Rob. It should bother anyone who has even passing interest in global macroeconomics or financial markets. With a growing share of exports in GDP, India is likely to be hit pretty hard if there is a sharp correction in the US cycle. This hit could come in the middle of the next plan period and send all the projections for a toss. Let's just hope Rob is proved wrong.

The author is chief economist, ABN Amro. The views here are personal abheek.barua@in.abnamro.com