The National Picture

Despite the effects of damaging hurricanes, I expect the nation’s economic expansion to continue, but with a moderate slowdown in the pace of growth.

U.S. GDP will rise by 3 percent in 2006, lower than both the 3.3 percent increase expected for 2005 and the 4.2 percent rate reported for 2004. The severe economic damage and extensive disruptions associated with hurricanes Katrina and Rita dramatically lowered GDP growth in the final two quarters of 2005, and diminished prospects for growth in the first portion of 2006.

Several pre-Katrina factors will contribute to a deceleration in U.S. GDP growth: slow growth in consumer spending for goods, particularly durable items such as automobiles; a drop in spending for residential real estate; the Federal Reserve’s interest rate hikes; a lessening of pent-up demand for big-ticket consumer goods; and extremely high levels of consumer debt coupled with virtually no savings.

In 2006, several factors will work to keep GDP growth strong: stepped up spending by federal, state and local governments; gains in nonresidential construction; more high-wage job growth; and a rapid rise in spending by businesses for equipment and software that nonetheless will not gather speed. From a national economy perspective, the beneficial economic impacts of hurricane reconstruction activity should outweigh the lingering negative economic impacts of the storm by mid-2006.

Risks to the baseline forecast appear to be well balanced. On the plus side, productivity gains could be stronger than expected, which would spur growth while containing both inflation and interest rates. Reconstruction of hurricane-devastated areas also could progress faster than expected. Other potential positive developments include lower than expected oil prices, even stronger housing markets, further acceleration in businesses’ spending for investment, and stronger than expected growth in foreign GDP.

The major downside risk is that there is less spare capacity than expected, which would tend to push up both commodity prices – including oil – and labor costs, generating widespread and accelerating inflation. The Federal Reserve’s likely response would be to hike interest rates aggressively, something that would hit debt-heavy consumers hard.

In this scenario, foreign investors’ diversification away from the dollar would likely reinforce inflationary pressures and the rise in interest rates. The overheated housing market might crash and confidence would falter. A broad-based slowdown in spending by both consumers and businesses would push the U.S. economy into a mild recession.

Another significant interruption in the supply of crude oil and/or refinery products on the heels of hurricanes Katrina and Rita could make prices climb rapidly; and another energy crunch – one stemming from supply interruptions rather than robust demand growth – might cause the U.S. and global economies to fall hard and fast.

However, the 2006 economic outlook assumes that the baseline forecast prevails.In 2006, total nonfarm employment will expand by 1.5 percent (about the same as 2005), lowering the unemployment rate slightly and accelerating wage growth.

Several factors will prevent job growth from accelerating. First, the anticipated slowdown in GDP growth will restrain hiring. Second, productivity will continue to rise, and GDP will grow only slightly faster than productivity.

Third, the outsourcing of U.S. jobs to developing countries will continue to spread from blue-collar occupations in manufacturing to white-collar occupations in high tech and service industries, which historically have been relatively immune to such practices.

Even devaluation of China’s currency relative to the dollar will not help U.S. manufacturers. U.S. labor costs are so much higher than China’s that there is no realistic devaluation capable of substantially altering outsourcing trends. Fourth, rapidly rising benefit costs are making it much more expensive for U.S. companies to hire workers.

In 2006, employment will rise fastest in the nation’s professional and business services. Leisure and hospitality, transportation and warehousing, and health services will see substantially above-average employment gains. Below average growth is expected in wholesale trade, retail trade, construction and government.

Manufacturing employment will continue its prolonged decline and utilities and logging also will lose jobs.