Rising interest rates and deteriorating housing affordability will lead to a downturn in residential construction. Then, as home price inflation subsides and home equity cash-outs diminish, consumer spending growth will moderate. Weaker performances in the housing and consumption sectors will be partially offset by strengthening business investment. Record corporate profits, technological advances, growth in global markets, and high energy prices will fuel a 10.3% increase in real capital spending in 2006. Foreign trade will be a drag on U.S. growth for one more year, until further dollar depreciation sparks a new acceleration in exports in 2007.

The new year will begin with a crescendo, as recovery from the devastating Gulf Coast hurricanes proceeds. Energy and chemical production will continue to rebound and reconstruction activity will pick up. After the first few months, however, the economy's growth will dip below its potential rate - currently in the 3.3-3.5% range. Real GDP growth is expected to slow from a 3.8% pace in the first quarter of 2006 to an average of 3.0% over the remainder of the year, as cooling regional housing markets become a significant drag on the U.S. economy.

Inflationary pressures are surfacing in response to above-trend growth and the squeeze of high energy and commodity prices. U.S. consumer prices rose 3.5% during the 12 months ended in November, although core inflation was just 2.1%. The nation's unemployment rate has declined from a cyclical peak of 6.3% in mid-2003 to 5.0% - its full-employment rate - and is expected to settle at 4.8% in 2006. Wage inflation, which has been subdued in this expansion, is beginning to pick up. Yet, productivity growth remains fairly robust (3.1% in the past four quarters) and should help to keep unit labour cost increases in the 1.0–2.0% range over the next few years. If oil and natural gas prices retreat in 2006–07, inflation is unlikely to become a problem. Our forecast calls for overall CPI inflation of 2.4% and core inflation of 2.3% in 2006.

Since mid-2004, the Federal Reserve has slowly and steadily tightened monetary policy, raising the federal funds rate from 1.00% to 4.25%. In its 13 December minutes, the Fed noted that 'some further measured policy firming is likely to be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance.' We expect two more rate increases in January and March, bringing the funds rate to 4.75%, which is within its 'neutral zone'.

Federal fiscal policy will provide some mild stimulus in 2006, reflecting a new prescription drug benefit for seniors and additional outlays for hurricane disaster relief, flood insurance, and infrastructure spending. The federal budget deficit is projected to widen from US$318 billion in fiscal 2005 (ended 30 September) to US$359 billion in the current fiscal year. Beyond 2006, the deficit is assumed to narrow through a combination of higher revenues and firmer spending restraints.

In recent months, the dollar has appreciated against the major currencies, as stronger U.S. growth and higher interest rates made dollar-denominated assets more attractive. Meanwhile, the U.S. current-account deficit has ballooned to US$800 billion in 2005 and is expected to approach US$900 billion in 2006. Once the Fed stops hiking interest rates early next year, we expect that investors will take a more pessimistic view of the dollar, leading to a broadly based depreciation over the next three years.

Raul Dary

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Lexington, MA 02421, USA
Tel: 781.301.9314
Cel: 857.222.0556
Fax: 781.301.9416
raul.dary@globalinsight.com

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