Steady as she goes

Steady as she goes

The U.S. economy rebounded at the end of the year on the back of unseasonably warm weather and lower oil prices. The advance report on fourth-quarter GDP showed surprisingly strong economic activity and reassuring inflation data. To be sure, unseasonably warm weather during December helped, but the growth was encouraging nonetheless and better than anticipated, certainly relative to two or three months ago.

Despite a big reduction in automobile production as car manufacturers moved to cut bloated inventories, real GDP in the quarter expanded 3.5 percent at a seasonally adjusted annualized rate, accelerating from soft and below-potential growth of 2 percent and 2.6 percent in the two previous quarters. For 2006 as a whole, the U.S. enjoyed robust economic growth of 3.4 percent, up from 3.2 percent in 2005 and above its 20-year average of 3.1 percent.

Details of the GDP report indicate that consumer spending - buoyed by last fall's large drop in energy prices and solid income gains - paced the growth by increasing 4.4 percent. Government spending grew 3.7 percent, while net exports contributed 1.6 percentage points, close to half of total growth, as exports surged 10 percent and imports fell 3.2 percent.

Residential investment plunged 19.2 percent, the largest decline in the current housing slump, while fixed business investment slipped 0.4 percent. Inventories accumulated at a slower pace than in the prior quarter, thereby subtracting 0.7 of a percentage point from growth.

The large drop in auto production and the reduction in inventory building should work as positive factors for economic growth during the current quarter.

On the inflation front, the core PCE deflator (prices for personal consumption expenditures such as food and energy), the Federal Reserve's favored inflation gauge, rose 2.1 percent in the fourth quarter, just a tad above the top of the 1 to 2 percent range with which most Fed officials seem comfortable. On a year-over-year basis, the core PCE deflator was 2.3 percent higher, slightly better than the third quarter's 2.4 percent rate.

Looking ahead, PIERS Global Intelligence Solutions anticipates continued solid growth for the U.S. economy in 2007. Real GDP growth of 2.5 percent is expected for the current quarter, with a pickup to 3 percent in the second quarter. In the second half of the year, we see real GDP expanding by some 3.25 percent on average. Should that growth profile materialize, real GDP would register growth of 2.9 percent for full-year 2007.

A key factor that continues to underpin the economy is the relatively accommodative nature of overall financial market conditions, which have been helped by rising stock prices and the weaker trade-weighted U.S. dollar. Improvement in these areas has come even though bond yields have firmed and financial markets have unwound much of the Fed easing that had been priced in earlier. At the same time, the earlier dive in energy prices continues to support household purchasing power.

As before, the outlook hinges heavily on how developments in the housing market unfold. Although there have been signs that housing demand is stabilizing, we are certainly not out of the woods yet. PIERS expects the housing sector will continue to act as a drag, albeit at a diminishing rate, on the economy over the first half of the year. By the second half, however, we expect housing to start contributing positively to economic growth. Auto production will also rebound in the first quarter.

Meanwhile, against the backdrop of strong labor markets and sturdy income gains, household spending should remain solid. Business investment, supported by healthy earnings growth, should accelerate from the past quarter's (temporary) weakness. And exports are likely to continue their strong performance as the global economy is forecast to record another year of strong growth and past/prospective dollar depreciation improves the competitiveness of U.S.-based producers.

With growth recovering toward trend, and core inflation likely to ease somewhat further, we expect the Fed to stay on hold over the course of 2007. The risk to our call on monetary policy is tilted to the upside, with rate hikes possible if the economy outperforms our expectations and inflation pressures pick up again.