The following review of economic trends is based on information available as of September 15, 2005.

The domestic economy as we experienced it through July and most of August can best be summarized as, literally, the calm before the storm. Rising crude oil prices were a source of concern as they settled into the mid-$60s per barrel, but this situation fell short of a crisis. The stock market experienced a hiccup or two, but investors took matters in their stride for the most part. That could very well change in the wake of Hurricane Katrina, with its residual impacts. But first, a look back at the pre-Katrina economy.

Gross Domestic Product (GDP) grew 3.3 percent in the second quarter, according to the U.S. Commerce Department, down slightly from 3.8 percent growth in the first quarter. About two-thirds of the second-quarter growth can be attributed to consumer spending. The Commerce Department further tells us that, in July, American consumers spent more than they earned for just the second time in the last 46 years. This is based on 0.3 percent growth in personal incomes for the month against a 1.0 percent increase in spending, resulting in a negative savings rate, a situation possible only if consumers spend by selling assets, dip into savings or borrow against future income.

Why haven't rising oil prices caused consumer spending to slow? The answer: cheap goods from Asia and a continually surging housing market, which have allowed many homeowners to increase their disposable income via mortgage refinancings and home equity loans. The American consumer does have a fickle side, however, if the Conference Board's Consumer Confidence Index is a reliable gauge. This monthly survey, based on a representative sample of 5,000 households, rose in June for the second straight month, then fell in July by almost the same amount it had risen the previous month. August's reading showed the Index rebounding to almost the level it settled at in June.

The Bureau of Labor Statistics indicated that weekly salaries in 2004's fourth quarter rose 5.7 percent, due largely to commissions and year-end bonuses. This helps explain why the national income seems to be steadily rising, despite anemic growth, if any, in hourly wages. Federal tax coffers also received a surprisingly large infusion from these same sources, thereby helping to reduce the federal budget deficit.

The Federal Reserve Board (the "Fed") again raised short-term interest rates by one-quarter of a percentage point (or 25 basis points) in August to 3.5 percent. Another similar increase is expected from its September 20 meeting. Most observers expect this rate to reach 4.0 percent in November, with a divergence of opinion over possible increases beyond that.

The Fed's overriding goal is to minimize inflationary pressures, especially now that higher energy costs may ripple into other sectors of the economy. Core inflation, which excludes such volatile contributors as energy and food, rose 1.6 percent for the 12-month period ending July 31, 2005. That figure rises to 3.2 percent when energy and food are included. Fed Chairman Alan Greenspan has steadfastly refused to allow the Fed to adopt a formal target rate for the purpose of containing inflation. He also reiterated his opposition to calls for the Fed to preemptively burst asset bubbles in the stock and housing markets, reasoning that the Fed lacks the necessary knowledge to target asset prices. Despite short-term rate increases, yields on long (10-year) Treasury notes continue to remain low, frustrating Fed policymakers who are concerned about the seemingly overheated housing market. Yields on long notes are the accepted benchmark for mortgage rates.

Another note on the effects of fuel prices on the nation's economy -- many economists have expressed uncertainty over where we may be headed. The quick price spikes of the 1970s, which have been used to inform the current debate, are perhaps inapplicable here as they resulted from supply manipulation. Today's situation is one of increased demand with generally constant supply. Demand will only increase as China and India compete with the U.S. for what are expected to be diminishing supplies. The U.S. Department of Energy estimates that every 100 percent increase in the price of crude oil sustained over a year can reduce this country's GDP by one point from what it would otherwise have been.

As for a post-Katrina economy, an article in the September 1 issue of The Wall Street Journal posited best- and worst-case scenarios as a result of the oil and gasoline supply disruptions in the Gulf of Mexico. The best case is a mere 5 percent cut in supply, with GDP suffering by one-half to one full percentage point in late 2005. The worst case is a 10 percent supply reduction, which could possibly cut GDP by three percentage points and lead to a recession.

One silver lining, however thin it might be, is that inventory growth slowed during the second quarter, meaning that future demand will have to be met from increased current output and not from stock already sitting in warehouses.

Corporate profits remained flush, increasing 17.7 percent in the second quarter on a year-over-year, pretax basis, or 11.5 percent after taxes are factored in, according to the Commerce Department.

The stock market rallied in July, with the Standard & Poor's 500^® Stock Index reaching a four-year high. Prices receded a bit in August, but resisted a slump in Katrina's wake with a September rally. Small-cap and mid-cap issues advanced at about the same pace. Large-caps lagged their smaller brethren, although they also advanced. Most sectors have thus far had a favorable third quarter, with telecom the exception. Energy was the hot sector, up more than 14 percent for the third quarter at press time, which boosted price returns above 35 percent for the year to date. Information technology and utilities enjoyed healthy growth of more than 5 percent for the quarter to date.

As noted earlier, yields on 10-year Treasury notes, which began the third quarter slightly below 4 percent, have risen above the 4 percent threshold since then. The U.S. dollar avoided any volatile swings, essentially holding steady against the euro.

Source: The Wall Street Journal

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The above article is for general information only and is not intended to provide specific advice or recommendations for any individual. Consult your attorney, accountant, or financial or tax adviser with regard to your individual situation.

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