SERIOUS MONEY:THE DELUGE of economic data that has fallen short of market expectations has been relentless in recent weeks. It is now certain that the US economy suffered a material slowdown in economic growth towards the end of the second quarter.

The loss of momentum heading into the year’s second half is of concern given that the support provided by fiscal stimulus and the inventory cycle is set to fade.

Reliable leading indicators of economic activity suggest that a double-dip recession is virtually assured. Whether or not the economy actually registers negative growth in upcoming quarters is beside the point – the fact remains that economic momentum is unlikely to be sufficiently strong in the year ahead to reduce the disturbingly large output gap. With calls for fiscal austerity growing louder, the risk that the US economy slips into deflation continues to rise.

The sharp slowdown in the pace of economic activity has been confirmed by a consistent flow of disappointing data releases.

Consider just a few:

- The University of Michigan’s index of consumer sentiment plunged almost 10 points to its lowest level since last August, and the magnitude of the drop has been matched just seven times in more than 30 years;

- Retail sales registered back-to-back declines month-on-month in May and June, an atypical development during an economic expansion;

- The level of outstanding consumer credit declined at an annualised rate of 4½ per cent during May, the largest drop on record in absolute terms and the 15th decline in the last 16 months.

Data from the manufacturing sector also points to a significant slowdown in economic activity. Factory output declined in May, and recent surveys indicate that the loss of economic momentum continued through June. The Empire State Manufacturing Survey’s general business conditions index dropped 15 points and is too close to double-dip territory for comfort. The same is true for the Philadelphia Federal Reserve Bank’s business activity index.

The message from the regional surveys is corroborated by the National Federation of Independent Business’s latest survey of small business economic trends, which shows that small business optimism declined last month to its lowest level since last December, and remains firmly in recession territory. The survey reveals that poor sales remain the sector’s biggest concern as both prices and volumes continue to disappoint.

The disappointing activity data coincide with inflation reports that suggest the economy is edging ever closer to deflation.

The Consumer Price Index (CPI) dropped for the third consecutive month in June, a development that has occurred on just six occasions since 1947. The core CPI excluding food and energy did register a modest increase, but a sizable advance in tobacco prices accounted for most of the rise, while the year-on-year gain remained at a multi-decade low.

The annual rate of inflation is well below the Federal Reserve’s long-term objective of 1.7 per cent to 2 per cent, but the minutes from the monetary authority’s most recent policy meeting reveal that it is not particularly concerned by the deflation risk. Indeed, developing and testing instruments “to exit from the period of unusually accommodative monetary policy” appeared to rank higher on its agenda.

The Fed should be worried, however, as real final demand growth has averaged a sub-par annualised pace of just 1½ per cent in recent quarters in spite of sizeable fiscal stimulus and near-zero interest rates. This could slow to just 1 per cent in the second half of the year in the absence of any further boost from inventory restocking and fiscal stimulus.

That level of growth will only intensify the deflationary pressure as it implies neither an improvement in an already underemployed labour market nor a reduction in surplus manufacturing capacity.

The traditional monetary policy mechanism is already proving ineffective because of an increase in the non-financial private sector’s precautionary money balances and reluctance on the part of a recuperating banking system to lend. A downshift in economic activity could well lead to a further increase in the non-financial private sector’s demand for money and a reduction in banks’ credit creation, which could become self-perpetuating should the change in the price level fall below zero.

Meanwhile, the reduction in aggregate demand caused by an increase in the private sector’s financial surplus could be exacerbated by the administration’s futile attempts to reduce the fiscal deficit.

There is no dispute that the trajectory of US public debt is on an unsustainable path, but now is not the time for fiscal austerity.

The world’s largest economy stands on the edge of a deflationary abyss yet the government is debating fiscal austerity. Meanwhile the monetary authority is discussing exit strategies from its accommodative policy stance. The risks of a policy mistake are looming larger; the time for further fiscal and monetary stimulus is now.

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