Outlook and Market Review - First Quarter 2006

Summary: 

The economy grew at a 4.8% real rate in the first quarter according to preliminary data released by the Commerce Department. Labor markets are tight with a 4.7% unemployment rate, but employment costs remain relatively low. The Employment Cost Index rose only .6% in the first quarter compared to consensus estimates of .9%. Capacity utilization edged up above 80% to what might be considered full employment levels. Price pressures from oil and commodities are partly offset by strong profit margins allowing business to absorb part of the price shocks rather than engage in inflation pass through. Both consumer spending and private investment rebounded from dismal fourth quarter levels.

Growth in the second quarter will be slowed by a number of factors taking shape in the economy. Housing demand is cooling off and the price of the median house price actually dropped in March. Housing inventories are building but demand is slumping due to higher interest rates, especially for adjustable rate mortgages. A housing slowdown in the remainder of 2006 will be a drag on growth. Gasoline prices appear to have peaked, but consumers are diverting more spending toward transportation and away from other goods and services. The Fed is not accommodating higher energy prices with an expansion of the money supply, which should dampen economic activity.

Inflation continues to be a risk factor. Low wage growth and a slowdown in benefit costs have helped keep inflation in check. Rising energy costs have been partially absorbed by businesses. Going forward, the tight labor market may require higher employment costs. Profit margins may eventually be too narrow to prevent inflation flow-through. Most analysts expect the Fed to pause after moving the Fed Fund rate to 5% in May, but any spurt in inflation may bring on another round of higher interest rates. An inflation bias is likely as the markets undergo adjustments to higher energy prices. A slumping housing market is the only sector where prices are likely to hold steady or fall.