How the U.S. Is Riding Out The Energy Storm Broader demand plus lower inflation and interest rates help bolster growth U.S. Economy Soft patch? What soft patch? Looking at the economy's growth rate during the first three quarters of the year, if s difficult to see what all the fuss was about. Clearly, the pace of payroll gains and consumer spending slowed in the spring, but look at the overall result: Real gross domestic product grew 4.5% in the first quarter, 3.3% in the second, and monthly data suggest growth in the 4% to 5% range in the third. Even with the drag from higher energy prices, real GDP for all of 2004 stands a good chance of expanding by 4% or better. It's not that costlier oil isn't having an impact. It most certainly is. Because the U.S. has net imports of about 4 billion barrels of oil and petroleum products annually every $10 per barrel rise in the price of oil diverts about $40 billion of U.S. income to foreigners. That's income that otherwise would have accrued to households and businesses as wages or profits. Multiplier effects, as the higher costs travel through the economy, tend to increase the overall impact. A rise in oil prices from $30 to $50 has the potential to cut as much as one full percentage point from economic growth. But to focus on oil is to miss a crucial point: Thanks to several key factors, this economy has managed to weather the energy storm so far. First, consider the timing of this latest oil spike. Unlike the $20-per-barrel jumps in the price of crude in 1990 and 1999-2000, the current hike has occurred at the beginning of a business cycle, not toward the end of one, when the economy would be more vulnerable to shocks. Second, the recovery is broadening. Output is becoming less dependent on consumer spending as capital investment, inventory growth, and exports accelerate. In addition, the oil spike has not pushed up other prices. Inflation, after scary jumps in the spring, eased back in July and August. Besides fueling a bond-market rally, that gave a lift to household buying power. Lower mortgage rates have buoyed housing and triggered a rebound in mortgage refinancing. Plus, despite being hit by higher costs and facing tough comparisons from the previous year, corporate profits last quarter are expected to post a solid double-digit gain. MOREOVER, MOST OF the economy's adjustment to $50 oil has already occurred, at least with respect to gasoline prices. Based on the historical relationship between the quarterly averages of oil and gas prices from 1985 to 2003, crude oil at $38 per barrel-its average in the second quarter-yields pump prices of about $1.75 a gallon. But in this past second quarter the average gas price was $1.96 per gallon. That price is historically consistent with oil costing about $46 per barrel, and the May peak in gas prices of $2.06 implied oil at $50. Fast-forward to October. Gas is running about $1.94 right in the range of what would be expected with crude oil at the $45 to $50 level That suggests there is little reason to expect a big runup in prices at the pump. Even after considering higher prices for natural gas and heating oil through yearend, economists at J.R Moifan Chase & Co. estimated that 70% of the impact of $50 oil has already been absorbed in household spending. Despite that oil adjustment, consumer spending was still able to rebound strongly in the third quarter. Real outlays appear to have grown in the ballpark of 4.5%, compared with 1.6% in the second quarter. That increase, along with positive trends in other GDP components, suggest real GDP will post growth in the 4% to 5% range when the Commerce Dept. makes its report on Oct. 29. Car buyers weren't so strapped last quarter that they couldn't take advantage of a good deal. Withgenerous sales incentives in place, carmalters sold autos at an annual rate of 1?.5 million vehicles in September. That brought sales for the quarter to 12.1 million, the best quarterly showing of the year. The problem for the fourth quarter is that, if incentives fade, sales may drop, AND WHM ABOUT 2005? The chief worry is that oil, which topped $52 per barrel on Oct. 6, could hold at $50 into next yearor ratchet higher. The danger is not so much the hit to consumers but a new round of oorporate caution and cost-cutting. That would threaten the rebounds in capital spending, inventory building, overseas demand, andmost importantjob growth. Economists, who gathered at the annual meeting of the National Association for Business Economics in Philadelphia on Oct. 3-5, generally believe the economy has the momentum to advance at a solid pace for the rest of this year and next. The NABE's panel of forecasters project growth of 4.3% in 2004 and 3.2% in 2005. Those numbers are down from May projections of 4.2% and 3.8%, respectively. However, when polled in early September, before the latest runup in oil, the economists said they expect the price of crude oil to fall to $40 by yearend and to $35 by the end of 2005. They also believedjob gains in 2005 will average 20,000 per month, business investment will rise 9%, and 10% growth hi exports will narrow the trade decit slightly. Those forecasts look reasonable, but they should be taken with a big caveat If the economists are wrong about oil, the other dominoes could fall as well. THE CRUCIAL RISK in the outlook is how businesses would hear up under the increased cost pressure in the event crude prices don't settle down in coming months. In recent periods of uncertainty, corporations have acted quickly to protect their bottom lines. Indeed, one issue of the NABB survey was the role uncertainty is playing in the labor markets. The forecasters ranked "cautious CEOs" as the third most significant factor, after productivity gains and inadequate demand, holding back job growth. Heading into 2005 any corporate hesitation could delay not only hiring but also capital spending plans, possibly dealing a blow to economic growth. Meanwhile, prots, although still growing solidly, are already set to slow for reasons other than energy. Productivity growth has slowed, as it usually does when recoveries gain traction. And unit labor costs are rising faster, boosted partly by increasing health-care costs. Profit margins are high. but they are coming under some pressure, as the ability to push through cost increases remains limited. Pricier energy threatens to intensify the pressure on margins and eamings. "No indicators that would signal whether companies are pulling back are monthly orders for capital goods and weekly claims for unemployment insurance. Through August, the three-month average of capital goods orders, excluding aircraft, has plateaued at a high level but has not lost ground. And through September, the four -week average of jobless claims remains low, holding below?350,000. So far, growth is holding up remarkably well with oil having rst touched $40 per barrel back in May. That's a tribute to the economy's underlying strength. But make no mistake, at some expensive level, oil prices will cripple this economy. What we might be in the process of learning is that the economy remains resilient enough to grow at a decent clip even with oil at $50. - Questions: 1. Examine how changes in a micro economic variables affect the aggregate demand or aggregate supply and its impact on GDP. 2. Explain the situation that warranted incentive to promote car sales