Outlook and Market Review - Fourth Quarter 2006

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Advanced estimates by the Bureau of Economic Analysis shows an accelerated real GDP growth rate of 3.5% in the fourth quarter of 2006 compared to a revised 2% rate for the third quarter. Fourth quarter growth was well ahead of a consensus 3% forecast. For the year, GDP growth was 3.4%. Real final sales, measured as GDP minus the change in private inventories, posted an even stronger 4.1% annualized growth rate. The stronger than expected economic performance did not fuel inflation. The GDP deflator for the fourth quarter was 1.5% compared to rates of 1.9%, 3.3% and 3.3% in the prior three quarters. The Fed’s preferred measure of inflation, the core Personal Consumption Expenditure index (PCE), moved up 2.1% in the fourth quarter compared to a 2.2% increase in the third quarter. However, the stronger than expected GDP growth may raise inflation expectations going forward in 2007. The Fed is currently holding the Fed Funds rate steady at 5.25% with a slight bias toward raising the rate if inflation does not remain under control. The 3.5% growth rate is about 50 basis points above the generally accepted threshold for non-inflationary growth of the U.S. economy. The strong fourth quarter growth is likely to delay any Fed initiative to deal with the expected economic slowdown.

The outlook for the remainder of 2007 calls for an economic slowdown of growth to the 2% to 2.5% rate. The relatively tight labor markets reflected by the 4.6% unemployment rate and relatively high capacity utilization rates provide an inflation bias that is likely to emerge for growth higher than 3%. Consumer spending remains strong, but the housing slowdown should eventually move consumers back toward higher savings. A general slowdown in business investment in structures, equipment, and software should rein in growth. On the positive side, exports have picked up to provide some added support for growth. The chronic weakness of the dollar linked to increasing global expansion appears finally to be easing the huge trade deficit. On balance, the economy should generate slower growth without much added inflationary pressure, unless oil shocks occur.