Outlook 2007
Economy, stocks look set for a happy new year
At times, 2006 seemed like one of those I Love the '70s episodes on VH1, except more depressing. A far-off war going badly, an unpopular president, higher oil prices, creeping inflation-not to mention a pungent whiff of actual stagflation as the economy slowed. There was even another Rocky film. The recent passing of two '70s notables, Nobel Prize-winning economist Milton Friedman and former President Gerald Ford, only added to the sense of deja vu.
But don't look for 2007 to be a rerun, at least as far as the economy goes. "The inflation scare of 2006 is over," declares Kenneth Beauchemin, U.S. economist at Global Insight. Now Beauchemin, who expects inflation to drift lower this year to 2 percent, is admittedly being a bit sarcastic. He never really bought into the notion that higher oil prices by themselves spawn an economywide price surge. "Oil shocks are never the proximate causes of inflation," Beauchemin says. "They are by definition short-term. But they set the table for a scare, and then the media [play] it up."
Yet in the minds of many people, at least those who remember the '70s, higher oil prices do equal inflation. "The Federal Reserve must guard against the emergence of an inflationary psychology that could impart greater persistence to what would otherwise be a transitory increase in inflation," Federal Reserve Chairman Ben Bernanke told Congress last summer.
Stable prices. Although the Fed hasn't raised rates since June, it hasn't cut them either, despite a slowing economy (growth in gross domestic product fell to 2 percent in the third quarter from 5.6 percent in the first) and a sharp downturn in the housing market.
Making Bernanke's job easier in 2007 is recent good news about energy and housing, the main villains behind much of the stagflation talk. Oil prices are down nearly 25 percent from their high last summer, and even the latest core consumer price index report-the one excluding volatile housing and energy prices-was flat, showing that higher energy prices have failed to infect the rest of the economy. Over the past six months, the core rate is up just 1.1 percent on a yearly basis.
The worst might also be over in housing. Existing-home sales have risen in back-to-back months, and the damage seems to be relatively contained. Although the economy has grown at just a 2.3 percent annual rate in the past two quarters, according to First Trust Advisors, it has expanded at a brisk 3.3 percent rate excluding housing. There is "little evidence" that the ongoing weakness in the housing sector is spilling over to the broader economy, Simon Kwan of the Federal Reserve Bank of San Francisco noted in a recent report, and there are tentative signs that the housing sector may be stabilizing.
Consumers still seem to be digging deep into their wallets. The recent 1 percent jump in monthly retail sales was "a game-changer for those positioned for an imminent hard landing for the U.S. economy," says Mike Englund of Action Economics.
So rather than stagflation, it seems plausible that the American economy will experience a pleasant mix of growth and price stability. Continued strong consumer spending lies at the heart of the consensus Wall Street economic forecast for 2007, which is for the economy to grow roughly 2.5 percent with moderating inflation. That sounds about right to Quincy Krosby, chief investment strategist at the Hartford. "With a job market like this one, it's pretty hard for me to forecast a recession," Krosby says.
The skimpy 4.5 percent unemployment rate, the lowest since the '90s boom, hardly indicates just how strong the job market is right now. The economy added an average of 161,000 new jobs a month through November. Then add 68,000 to that number-that's how much the Labor Department thinks it's been undercounting job growth. Lots of jobs mean stronger wage growth, which keeps consumers spending. Hourly wages were up nearly 3 percent after inflation through November, and real disposable personal income grew a solid 0.3 percent in November.
Good times. You also don't forecast a recession when corporate profits are surging. Adjusted pretax profits rose at a 17.7 percent annual rate in the third quarter, according to JPMorgan Chase. "The economic backdrop is a healthy one," says Bruce Kasman, the firm's chief economist.
So what is the Fed's next move? Judging by the 30-day federal funds futures contract traded at the Chicago Board of Trade, investors are betting that the Fed might cut rates by a quarter point some time in mid-2007. A hike in rates would be a nasty surprise, particularly to stock investors who are wagering on a soft landing. That bet is a big reason behind the Dow's late-2006 run to a record high. Wall Street will continue to obsessively pore over the inflation and housing data, especially, as it frets about the Fed overtightening.
Still, as the various economic reports trickle in during the first part of the year, get ready for a bumpy ride at times. "I think we will be struggling to make sense of the data," Krosby says. "Some days it will look like a recession is around the corner and the next that data will defy that conclusion." So just keep on truckin', brother. Everything's going to be copacetic.
This story appears in the January 15, 2007 print edition of U.S. News & World Report.