January 5, 2006

The 2006 Economic Outlook: It May Be Better Than You Think

by Todd P. Martin - economic adviser to People's Bank

It's the time of year to reflect on how well the economy performed during the last 12-months and to dust off the crystal ball and take a look at what's in store for 2006.

What can we say about the U.S. economy in 2005? The big lesson I take away is its resilience. Despite the formidable headwinds we faced this year - devastating hurricanes, skyrocketing energy prices, higher interest rates, the war in Iraq and consistently negative press coverage about all of the above - the economy turned in another remarkably strong performance. In the third quarter, when Hurricanes Katrina and Rita hit the South hard and gasoline prices spiked to over $3.00 a gallon, the economy still grew at a robust 4.3 percent pace.

So why are people so pessimistic? Incredibly, the economy has now expanded at better than a 3.0 percent pace in each of the last ten quarters, averaging 4.1 percent growth during that period, while the unemployment rate has fallen from a 6.3 percent cycle high to just 5.0 percent. But the general public doesn't appear to be getting this message.

Chicago economist Brian Wesbury, who USA Today rated one of the nation's top 10 economic forecasters in 2004, notes that while conditions have steadily improved, the number of Americans that believe the economy is in recession has actually increased from 36 percent in 2004 to 43 percent currently.

But what people say and what they do are two different things. Never underestimate the will of the American consumer to spend. This is not to say that 2006 will be challenge free. There will be hurdles, but many of them will be the same ones we faced at this time last year, including, among the usual suspects, rising interest rates, a potential housing bubble, higher energy prices, the war in Iraq and growing budget and trade deficits. Still, despite these concerns, the economy came through better than anyone would have expected.

It is likely to do the same again next year, though at a decidedly slower pace. Overall, real Gross Domestic Product growth (the value of all goods and services produced in the United States) should decline somewhat from its current 4 percent pace to about 3.0 to 3.5 percent, as the Federal Reserve continues to gradually increase short-term interest rates to keep inflation in check.

The Fed, however, should be close to taking a breather from its tightening of monetary policy shortly after Ben Bernanke takes the reins from Alan Greenspan in late January. The targeted fed funds rate (the interest rate banks charge one another for overnight loans) will probably be increased to 4.5 percent from its current 4.0 percent level by early spring. This rate is up significantly from just 1.0 percent in 2004.

After this hike, however, by mid-year, Mr. Bernanke and his colleagues will likely want to test the economic waters and hold off on future rate increases as they determine how well the economy reacts to those already implemented. Changes in monetary policy typically take 6 to 18 months to take hold.

The Fed may take a rate-rising break because the central bank must achieve a delicate balance between keeping inflation in-check and ensuring they don't cause an abrupt collapse in the housing sector - which has been the strongest sector of the economy in recent years. The Fed would like to see a gradual moderation in the pace of the white-hot housing market in terms of price appreciation and building activity.

The flattening yield curve (the narrowing spread between short and long-term interest rates) may also cause the Fed to stop tightening. Currently, the yield on 10-year Treasury notes is about 4.5 percent, which is just slightly higher than the fed funds rate. If the Fed continues to push short-term interest rates too much higher, there is the risk of an inverted yield curve (short-term rates moving higher than long-term rates). In the past, an inverted yield curve has been one of the best signals that the economy may be slowing or even headed for a recession.

This environment should be relatively favorable for the Connecticut economy. While Connecticut has lagged the rest of the country in terms of job growth during the current business cycle, we have continued to do quite well in terms of output, income, and productivity. The state probably created about 18,000 net new jobs in 2005 and is likely to generate a similar number next year. But even at this pace, we still will not recapture all of the 60,000 jobs we lost during the last downturn. In contrast, the rest of the country has already regained 200 percent of the 2 million jobs lost during 2000-2002. Connecticut has recaptured only about 60 percent of the jobs we lost from 2000-2003.

I guess you could say that Connecticut has become a victim of its own success. We continue to enjoy the highest per capita income in the nation, but our long-term viability is susceptible to our high costs (housing, taxes, electricity, etc.), traffic congestion, an aging population and a widening disparity in economic prosperity between our urban and suburban residents. In order to compete effectively in the future with other states - and perhaps more importantly, the rest of the global economy - Connecticut's business leaders, legislators, and educators must work together to develop policies and plans that can improve the longer-term business and research environment with a focus on education and innovation.

Despite these long-term challenges, next year is shaping up to be another good one for the U.S. and Connecticut economies. There is no doubt that there will be many surprises like there were in 2004, but the biggest surprise may once again be how healthy the economy turns out to be in the face of ongoing headwinds.