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SLOWER, MORE SUSTAINABLE GROWTH AHEAD FOR U.S. IN ’06

By Michael P. Niemira

The U.S. economy and the retail real estate sector performed very well last year, despite record-high energy prices, a round of disruptive hurricanes and a steady climb in interest rates. So what economic changes are likely for this year?

The chairmanship of the Federal Reserve Board is shortly to pass from Alan Greenspan to Ben Bernanke. But even aside from this changing of the guard, the Fed had signaled a change in its marching orders at its final meeting of 2005. The Fed statement opined 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.”

At long last, it seemed, the Fed was arguably approaching the end of a “measured” sequence of interest rate increases, undertaken at its last thirteen gatherings of the year (the end, at least, until it reassesses the economy and the inflation picture this year.)

Underlying inflation — that is, prices excluding food and energy — has remained tame through the energy spike of 2005, but the worry now is that the economy’s actual growth last year was in excess of its “potential” (meaning the rate at which growth can be sustained without putting upward pressure on inflation).

Though the measure of this potential is in the eye of the beholder, it is generally thought to be about 3.1 percent, based on estimates from the Congressional Budget Office, and the risk is that growth in excess of that rate for extended periods will cause inflationary pressures to build. Last year real gross domestic product expanded at a slightly better than 3.5 percent rate — not too much above potential, but higher all the same.

Most notably, there are changes afoot on the demand side of the economy that will slow growth this year and could relieve inflationary pressure. Behind the slowdown will be the usual suspects: housing and motor vehicle demand. Already the sales of both have cooled and are likely to continue to moderate as interest rates are expected to move a bit higher this year.

In a nutshell, some of the cumulative forces from higher interest rates and weakening consumer fundamentals, including high consumer debt levels and a negative savings rate, are likely to pare real GDP growth this year to a subpotential pace of 3 percent, with further moderation to 2.7 percent next year. Beginning this year and extending into early 2007, we expect the economy will experience a “minicycle” comparable to the 1995 slowdown, though the reason in this case will be quite different.

Our forecast is relatively quiescent on the surface, but there are questions:

• Will the growing current account deficit relative to GDP (which is likely to exceed 7 percent of nominal GDP this year) trigger a sharply weaker dollar? This is indeed a risk, one that will potentially affect capital flows and interest rates as well.
• Will employment grow fast enough to offset any “harder landing” scenario? Last year the average monthly increase in payroll employment was 179,000 jobs, versus an average of 124,000 per month the year before. During a “normal expansion,” the U.S. economy would typically be producing about 275,000 jobs per month.
• Will inflationary concerns return as a result of wage demands responding (as is typical) to past inflation?
• Will energy prices reverse course and boost the financial markets and the economy?
• Of course, there are additional risks. But our crystal ball tells us that 2006 is likely to be a year of economic transition toward slower, more sustainable growth.

Michael P. Niemira is ICSC’s chief economist and director of research.

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