After the rapid growth over the last one and a half year, the US economy slowed down in the second quarter this year. The second quarter GDP was revised downward to an annual rate of 2.8%. This represented an easing of 1.3 and 1.7 percentage points over the same period last year and last quarter respectively. The slowdown in the second quarter was mainly because of the reduction of personal consumption expenditures (PCE) and private inventory investments as well as an increase in imports.

Though the third quarter economic data showed mixed economic performance, the economic expansion was still intact. There were several bright spots, for example, the privately owned housing construction increased at a seasonally adjusted annual rate of 8.3% in July, the real PCE in July also increased at a seasonally adjusted rate of 0.8% and the factory orders increased 1.3% in July. This reflected that the US consumer spending and manufacturing sectors have regained traction after the slowdown in the second quarter. A survey of 55 economists by the Wall Street Journal on September 3-7 showed that the consensus estimate of the third quarter and fourth quarter real GDP growth are 3.6% and 4% respectively. This reflected that most Wall Street's economists expected the US economy will accelerate its expansion in the second half of 2004.

All in all, the U.S. economy would benefit from the US$674 billion tax-cut programme implemented by the Bush administration in early 2003. This 10-year tax-cut programme would have the largest expansionary effect in 2004. Under this scheme, the tax cuts in 2004 is expected to boost the economic growth by 1.1 percentage points and create more than 900,000 payrolls in the US economy. The US economic grew at a rate of 4.9% in the first half of 2004, or at an annualized rate of 4% . As the economic expansion is intact, it is expected that the full year economic growth would reach 4% in 2004, higher than the 3% in 2003. This is also the fastest growing year during the Bush administration.

2. Concerns about the economic structural problems over the medium and long term

The economic growth in 2003 and 2004 was mainly due to the expansionary effects from the tax relief, larger government expenditures and the lower interest rate in order to stimulate consumer expenditures and investments. However, such an economic environment would be changed in 2005. First, the momentums from the tax relief on PCE and private investments will lose its stream gradually after the presidential election. Second, the US interest rate is on the upward course. It is expected that the Fed would lift its key interest rate to around 3% in 2005. In reality, the side effects of the expansionary fiscal and monetary policies will affect the US economy in the medium and long term. They are analyzed as the follows:

(1) Worsening of the fiscal deficits

Over the past several decades, the US relied on the expansionary fiscal policy to stimulate economic growth which in turn created huge deficits. During the Reagan administration in the 1980s, the US government followed the theory of supply-side economics. The Reagan administration implemented an aggressive tax-cut programme in order to stimulate private consumptions and investments. As a result, it led to huge financial budget deficits. In the mid 1980s and early 1990s, the US financial deficits reached around 5% of GDP. It is until Clinton took the office, he implemented a series of economic measures to achieve a balanced financial budget. Those measures included an increase in tax rate and increase the government presence in the economic activities, etc. However, when President Bush took his office in 2000, he followed the supply-side economics theory again to stimulate economic growth through the tax-cut programme. As a result, the US fiscal deficits worsen again. The US Congressional Budget Office projected that Federal deficit in this election-year will hit a record US$422 billion which is around 3.7% of the GDP.

The US$674 billion tax-cut programme not only stimulated private consumptions, but also added the inflationary pressure. The higher inflationary pressure ended the four year long interest rate down cycle. The Federal Reserve raised the federal funds rate by 25 basis points in June. This formally started the interest rate hikes in the coming one to two years. It is generally expected that the Federal Reserve will raise the federal funds rate by 300-350 basis points in order to ease the inflationary pressure in the US economy.

The effects of the interest rate hike are still uncertain. One of the likely effect is that higher interest rate would hurt PCE which adversely affects the economic growth in 2005. Additionally, if the oil prices remained at high level, the production costs and imports prices would definitely go up. (For instance, the higher imports prices in July and August were partly due to the rise in oil prices). Higher prices together with slow economic growth would lead the economy into stagflation. Obviously, huge financial deficits would greatly affect the US economy in the medium and long term.

(2) Current account deficits reached record high

The worsening of the current account deficits showed the structural problems of the US economy. Actually, the US economy did not have any current account deficits in the early 1990s. In 1991, it even recorded a small surplus. However, the situation worsened since 1992. In 2003, the current account deficits increased to US$530.7 billion, more than tenfold of the US$48 billion in 1992. In the first half of 2004, the seasonally adjusted deficits amounted to US$313.3 billion, up more than $54 billion or 21.2% from the last six months. Therefore, the annualized current account deficits would amount to US$627 billion this year. Indeed, the current account deficits were mainly due to the large deficits on goods and unilateral transfers which amounted to US$547.6 billion and US$67.4 billion in 2003 respectively. As a result, even though the net exports of services and net income receipts from investments amounted to US$51 billion and US$33.3 billion respectively, it failed to offset the huge deficits created by the commodity trade.

Obviously, the worsening of the US current account deficits will affect the investors' confidence on the US dollar. This might lead to speculation on US currency devaluation, as well as the outflow of US dollar assets. This will then adversely affect the capital account balances. At present, the US mainly relies on the capital account surplus to offset the current account deficits in order to achieve balance of payment. The outflow of US dollar assets would reduce the surplus in the capital account which would definitely affect the US international payment position. This may also affect the US and global financial markets stability.

(3) Economic growth relied heavily on PCE

From the perspective of economic growth, the US economic structure has experienced significant changes over the past four years. From 2000 to 2004, the average annual growth rate of PCE and government expenditure were 3.4% and 3.2% respectively. Both were higher than the overall GDP growth rate. On the other hand, the annual growth rate of the private investments decreased 0.05% while the exports of goods and services only grew at 0.7% annually.

As a result, the share of PCE of the GDP increased 2.7 percentage points from 67.8% in 1999 to 70.5% in 2003. The share of government expenditure also increased 1.4 percentage points from 17.5% to 18.9%. The share of private investment fell from 16.8% to 15.1%. Finally, net exports worsened from -2.8% to -4.5%. This trend of economic growth continued in the first half of 2004.

The 70.5% share of PCE of the GDP in 2003 reached a record high since the Second World War. This was about 4 percentage points higher than the average PCE level over the past twenty years (1983-2002) and was also the highest among the G7. Based on the data in 2002, the PCE share in the U.S. was 11 percentage points higher than the average of the other six industrial countries.

The strong dependence on the PCE in the US economy mainly reflected the poor investment environment and weak tourism industry after the 9.11 incident. This showed the unbalance in the US economic development.

To conclude, the U.S. economic growth in the recent years is mainly contributed by two factors. The first one is to maintain an extremely low interest rate environment to stimulate the personal lending and spending. The second one is to implement expansionary fiscal policies to sustain the economic growth.

In the second half of 2004, the economic environment changed. On one hand, the lending cost is going up as the Fed will continue to raise its key interest rate. On the other hand, the budget deficit has reached 4% of the GDP. There is little room for the U.S. to rely on expansionary fiscal policies to further stimulate the economic growth. As a result, the current growth model which heavily relies on PCE to stimulate economic growth may not be sustainable in the medium and long term. The economic growth will unavoidably slow down in 2005.