The National Outlook

The U.S. economic expansion is in no immediate danger of running out of steam, but there will be a sharp deceleration in the pace of GDP growth due to the housing recession and other factors.

U.S. GDP will rise by 2.3 percent in 2007, lower than both the 3.3 percent increase expected for 2006 and the long-term trend rate of growth of 3.1 percent. The cool-down therefore will be slightly harsher than the proverbial soft landing, but not harsh enough to qualify as a hard landing. The GDP growth of 2.3 percent will be a respectable achievement for an expansion that is already a little long in the tooth. In January, this economic expansion will be 61 months old, exceeding the 57-month average of the 10 expansions since World War II.

It’s not just the expansion that’s fully matured. The current bull market, which started on Oct. 9, 2002, is already the second longest since World War II.

Aside from the housing recession, consumer caution will be the primary factor contributing to below-average GDP growth in 2007. I’m convinced that slower growth in consumer spending lies immediately ahead. Households’ inflation-adjusted spending will grow by only 2.2 percent, compared to 3.2 percent in 2006 – the smallest gain since 2001. The slowdown reflects the lagged effects of the Federal Reserve’s interest rate hikes, an expectation of no significant appreciation in asset values, and high levels of consumer debt coupled with the need to save more out of current income.

By almost any measure households are overextended. For example, the household debt service ratio – debt payments divided by after-tax income – reached an all-time high of nearly 14 percent this year. If you add in other financial obligations, such as automobile lease payments, rental payments on tenant-occupied property, homeowner’s insurance and property tax payments, you get a financial obligation ratio of nearly 19 percent – also an all-time high.

My call for a mid-cycle correction rather than an outright recession hinges on several developments. I expect U.S. export growth to accelerate and import growth to decelerate; net exports will make a significant contribution to GDP growth. Businesses’ spending for new equipment will continue to grow quickly, but not quite as fast as it has over the last few years.

Spending on nonresidential construction will accelerate; and the proportion of high-wage jobs created will rise even as total employment growth slows. Crude oil and gasoline prices should remain well below the peak level prices experienced in 2006. Finally, significant deceleration in inflation should reassure the bond markets and the Federal Reserve, making additional rate hikes highly unlikely.

Indeed, the Federal Reserve is likely to keep rates steady for an extended period. If most of my expectations are realized, the nation’s economy will experience continued, but moderate, economic growth, with a low risk of high inflation and a low – 25 percent – risk of recession.

The upside and downside risks to this forecast appear to be well balanced. On the plus side, productivity gains could be stronger than I expect, which would spur GDP growth while containing both inflation and interest rates. Bearish bond investors might push down long-term interest rates, which could revive the housing market.

Other potential positive developments include lower than expected oil prices, acceleration rather than deceleration 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, which would hit debt-heavy consumers hard. In the wake of higher interest rates the ongoing housing recession would intensify and confidence would falter. A deeper and more broadly-based downturn in spending by both consumers and businesses then would push the U.S. economy into a recession.

Another risk to the forecast lies in the oil and/or refined petroleum products markets. A second energy crunch – one stemming from major supply interruptions rather than robust demand growth – might cause U.S. and global economies to fall hard and fast. My 2007 outlook assumes that any extreme outcomes are avoided.