2006 economic outlook: continued growth.

There is little question that economic growth will continue in 2006; however, there are questions about the level of the growth and changes in trends in several important variables.

The U.S. economy appears to be only moderately affected by hurricanes Katrina and Rita. This is most evident in the job market. Employment gains have been strong since the spring of last year. There was a net gain of 1.9 million jobs in October from a year earlier, even with the hurricanes' effects on the September and October changes in employment levels. Hiring in the rest of the country, at least so far, seemingly has not been affected. Indeed, claims for unemployment insurance outside of those being filed by displaced Gulf residents have, if anything, fallen. Employment growth will return and about 2.7 million jobs should be added in 2006.

Inflation and Interest Rates. Has the extended period of modest inflation and low interest rates ended? Consumer price inflation (CPI) in September was the highest it has been in the past 14 years, reflecting the recent increase in energy prices. However, core inflation (energy and food prices removed) remains amazingly contained at just 2 percent annually. The size of energy price gains and their impact on both consumer spending and inflation expectations make it a mistake to place too much emphasis on the core inflation rate. Consumer surveys have shown a sharp increase in inflation expectations. More businesses are openly saying that they are raising their prices.

The Federal Reserve Board (the Fed) is trying to dampen these expectations. The Federal Open Market Committee (FOMC) of the Fed will probably raise short-term interest rates again during its December meeting. The increase will be the same 25 basis points (100 basis points equals 1 percent) that occurred 12 times since June 2004. The coming increase will bring the Federal Funds Rate (the rate that banks charge each other for the borrowing of excess reserves) to 4.25 percent. Two additional 25 basis point increases early next year can be expected.

Ben Bernanke has been selected and confirmed as Chairman of the Board of Governors of the Federal Reserve System, replacing Alan Greenspan. He is expected to carry on in Greenspan's footsteps. He has served at the Fed under Greenspan, and his writings make clear his views on the need for the Fed to establish credibility in fighting inflation. In fact, one area where he may go farther than Greenspan is in inflation targeting. The Fed has already moved well down this path, in particular by increasing the transparency of its monetary policy and by moving proactively to combat inflation. However, a Bernanke Fed could take further steps, in particular setting an explicit inflation target.

The Fed's tightening of monetary policy and increased inflation expectations are beginning to affect long-term interest rates. The for-sale housing market has been torrid for the past two years. Mortgage interest rates, at more than 40-year lows, will moderate as rates rise. Tightening of monetary policy and the expectation of lower energy prices should moderate inflationary pressures by the middle of 2006 and permit the economy to continue its growth. Long-term rates have moved up about 40 basis points from early September through the end of October. They had been falling in spite of the Fed's moves on short-term rates.

Labor Markets and Consumer Confidence. Employment gains have been strong since the spring of last year. There was a net gain of 2.4 million jobs in September from a year earlier, even with the net loss of 35,000 jobs for the month. Hurricane-related job losses probably limited total employment growth in data for October. Employment growth will return and about 2.7 million jobs should be added in 2006.

Consumer confidence in both the Conference Board Index and the University of Michigan Consumer Sentiment Index recorded large declines in September, as the effects of hurricanes Katrina and Rita sent energy prices soaring and eroded consumer confidence. Both indexes showed further drops in October. However, there is reason to be optimistic. While energy prices have been unstable, they are retreating and should continue to do so, barring new shocks or an abnormally cold winter. Large increases in heating bills and publicity surrounding these increases are likely delaying any lift to confidence but will not prevent it from coming. Continued strength in labor markets is another important positive for confidence in the near term. Continued increases in interest rates will be a small negative for confidence in the near term but will be a large negative next year as they affect housing markets.

In sum, confidence should rebound, but only very slowly. Key drivers include gasoline and home heating prices, developments in labor markets and stock prices.

Growth. Normally, continued Fed tightening would have led experts to expect slower economic growth in 2006 than this year, but the hurricane and rebuilding have lessened growth for this year and added some for next year. As a result, don't look for slower economic growth coming from tighter monetary policy until the end of 2006 or in 2007.

Thus, based on the fundamentals discussed, inflation adjusted GDP will grow about 3.6 percent in 2006 and will be slightly higher than the 3.5 percent for this year. Support for economic growth will come from a highly stimulating fiscal policy and business investment. Business investment is rising in double digits after modest growth for the three previous years.

Trade Deficits and the Budget. There are cautionary factors: the twin deficits of trade and the federal budget. The trade deficit continues to set records that will extend to 47 consecutive quarters at the end of this year. The sharp declines in the value of the dollar should help exports and slow the growth in the trade deficit if oil prices moderate as expected. The United States is able to survive the large trade deficits with foreign countries holding more and more dollars, and if foreign countries stop or reduce investment in these funds in the United States, interest rates will come under more pressure.

The federal budget deficit will put added pressure on long-term interest rates. Federal budget deficits are now expected to total $2.1 trillion from fiscal years 2006 to 2015, according to forecasts by the Congressional Budget Office. This is in addition to the $1.3 trillion deficit accumulated in federal fiscal years 2002 through 2005. And these amounts do not include the federal expenditures for the terrorism wars in Iraq and Afghanistan and for hurricane relief and recovery in the Gulf Coast areas affected by Katrina and Rita.

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