The Outlook for 2007

The U.S. economy has been growing for 20 consecutive quarters. If the numbers for the fourth quarter of 2006 indicate the economy is still growing – which is extremely likely – the current U.S. economic expansion will have entered its sixth year, according to the National Bureau of Economic Research’s December data.

An expansion of this duration is above average. Of the 11 other economic expansions since World War II, only three have lasted longer, the bureau reports.

Economists are forecasting more of the same for 2007. In a survey by The Wall Street Journal, the consensus among 56 economists was for continued growth, but at a slightly slower pace.

The growth of real gross domestic product has averaged just over 3% since the current expansion began in the fourth quarter of 2001, according to Haver Analytics, a company that supplies databases on economic analysis. (Gross domestic product, also known as GDP, is the total output of goods and services by the U.S. economy.) In 2001, GDP was about $10.2 trillion. In 2006, it was on pace to exceed $13.3 trillion.

The economists surveyed by The Wall Street Journal expect GDP to grow at a 2.5% annual rate during the first quarter and to accelerate slightly to a 2.9% annual rate by the fourth quarter of this year. Although the economists are predicting that the economy will slow slightly during the year, this might not be a disadvantage because it could help keep inflation and, by extension, interest rates in check.

It is widely accepted that the U.S. economy can safely grow about 3% a year without causing high inflation. Economic growth in the 4% to 6% range might sound great, but such rapid growth can spark inflation and cause policymakers at the Federal Reserve to raise short-term interest rates, which can cause other problems that make a 3% GDP growth rate seem like a pleasant alternative.

Despite a record-setting jump in wholesale prices in November, the economists are looking for inflation to be moderate in 2007. The average forecast was for the consumer price index to grow at a 2.1% annual rate at least through May (forecasts for later in the year were not yet available). This is fairly low compared with the 25-year average of 3.1%, according to Thomson Financial.

Even though wholesale prices jumped 2% in November ‘06, the biggest increase in 30 years, the increase was widely viewed as a one-month quirk because of big price declines in the previous two months. Wholesale prices fell by 1.3% in September and 1.6% in October. This unusual activity was almost certainly driven by volatility in energy prices. Energy prices fell significantly in September and October, but jumped 6.1% in November.

Inflation is a critical piece of the puzzle because it weighs heavily On Federal Reserve Board decisions about certain key short-term interest rates. The consensus among economists surveyed by The Wall Street Journal was for the Federal Reserve to cut the federal funds rate to 5% from the current 5.25%. The Federal Reserve began raising interest rates in June 2004 in response to inflation fears brought on by rapid economic growth, but paused after reaching 5.25% in June of last year. However, the Fed indicated after its December meeting that it is still wary of inflation and is still focused on deciding whether further increases are needed.

A cut in short-term rates at the Federal Reserve Board’s January 30-31 meeting would indicate that it sees the economy slowing in 2007 (results of that meeting were not available at time of print). An increase would indicate economic growth is brisk enough to justify inflation fears. Leaving the rate at 5.25% would likely indicate the Fed sees moderate growth potential, but not enough to cause higher inflation.

The unemployment rate was 4.5% in November, a decline from the 5% rate a year earlier, but a slight uptick from the 4.4% rate in October, says the Bureau of Labor Statistics. The surveyed economists are forecasting unemployment to increase slightly to 4.8% by May. However, a 5% unemployment rate has historically been considered full employment for the U.S. economy. Many individuals counted as unemployed when the rate is below 5% are likely to be transitioning between jobs and are out of work by choice or for only a short period.

The employment situation is a key indicator of economic health. A rosy employment outlook bodes well for consumer spending, which accounts for about two-thirds of U.S. economic activity. When more workers are earning income, consumer spending tends to go up, which can lead to more job creation. When unemployment rises, consumer spending tends to fall, which causes other workers to lose their jobs, leading to even greater unemployment.