Outlook and Market Review - Fourth Quarter 2005

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The advanced estimate of 1.1% real GDP growth in the fourth quarter of 2005 came as a big surprise to analysts who expected real growth to be about 2.8%. For the year, GDP growth was 3.5%, continuing a solid annual growth pattern for the third year in a row. Inflation driven by higher fuel prices picked up in 2005 with a 3.4% increase in the CPI. Core inflation remained within a lower band considered to be acceptable by the Fed. Labor markets tightened with unemployment dropping to 4.9% and below trend jobless claims. The Fed increased its Fed Fund target to 4.5%, which many economists believe to be a neutral rate. Further increases are unlikely unless inflation shows more strength. The Treasury yield curve remains very flat at intermediate and long term maturities, suggesting low inflation expectations in the market.

The unexpected weakness in the fourth quarter of 2005 will carry over to the first quarter of 2006 somewhat, but analysts continue to forecast good growth with moderate inflation. Job markets are likely to continue to strengthen as firms add jobs. Wages should continue the pattern of low pressure on costs, given global competition. Consensus estimates call for GPD growth of 3.4% for 2006, which is only slightly below the 2005 growth rate. The unemployment rate should remain close to the current 4.9% level. The consensus analyst forecasts call for lower inflation in 2006 with a median forecast of only 2.4% increase in the CPI. If this forecast holds true, it would be consistent with an end to incremental increases in the Fed Fund target.