US '07 economic outlook: slow growth, no recession

But less vibrant economy would give Federal Reserve less wriggle room for mistakes.

It looks as if it will be an uphill climb for the economy next year.

Growth could be the slowest in the past five years. The unemployment rate, already at a low level, is likely to rise. Business, which has been on a spending spree, is expected to cut back somewhat. The consumer, the bulwark of the economy, may not be spending quite as freely.

Despite this economic slo-mo, most economists expect a recession-free 2007, the sixth consecutive year without a downturn.

"There are risks ahead, but the basics look reasonably good," says Robert Hormats, vice chairman of Goldman Sachs International. "Many people thought the sharp weakening in housing would have a more crushing effect on the economy, but mercifully it hasn't."

Managing the slower economy will be a challenge for the Federal Reserve. It will have less leeway for mistakes. At the moment, many economists are anticipating that the Fed will cut interest rates starting in the spring.

"We are anticipating the Fed will make two cuts starting in March," says Jason Schenker, an economist at Wachovia Corporation in Charlotte, N.C. "The Fed will be under a lot of pressure to hit the cut button."

Exactly how much the economy slows – and when – is still a matter of dispute among economists. "There is a real tug of war over the outlook," says Robert Brusca of Fact and Opinion Economics in New York. "A lot of indicators are moving in different directions, so it's not surprising there is a lot of discord in the outlook."

On the negative side are a small group of economists who still think the economy will sputter into a recession next year. A member of the recession contingent is Hugh Moore, a partner at Guerite Advisors in Greenville, S.C.

He is focusing on a number of quantitative economic statistics, which he believes are signaling negative growth ahead. "We don't think it's dire, we don't think the economy will crumble," he says. "But we think the decline in housing construction and the reduction in home equity withdrawals [borrowing against a home's increased value] will be enough to put the economy into a recession in the second half of 2007."

Others think the economy will just barely get by without a downturn. Wachovia, for example, expects the nation's gross domestic product (GDP) will grow only 1.9 percent next year. The bank predicts the unemployment rate will rise from 4.5 percent to 5 percent.

Mr. Brusca thinks the weakness is short term. He sees the economy scraping by and building momentum by year-end. "By this time next year it will feel like a year of improvement," he says.

However, one sector that does not expect to see much improvement is manufacturing. Over the past two years, the sector has grown faster than the economy as a whole, says Dave Huether, chief economist at the National Association of Manufacturers in Washington. But in 2007, he expects manufacturing to grow 2.8 percent compared with 4.5 percent this year. "That's a significant slowdown," he says.

The sector's problems would be eased quite a bit by a strong end to this year's holiday season, says Brusca, who points to excess inventories at the nation's manufacturers. "If the consumer shows up, the problems fade away. If not, it's harder to get rid of the inventory," he says.

However, some consumers will be in for a rude shock, says David Kotok, of Cumberland Advisors in Vineland, N.J. Some $1 trillion in low-interest mortgages will reset at a higher interest rate in 2007 and another $1 trillion in 2008. "About 4 million to 5 million households will be negatively impacted," he estimates. "This is mainly people in the lower and middle class, the Wal-Mart shopper, not the Tiffany shopper."

In 2006, there was also a large uptick in interest costs for some borrowers. But the higher costs were partly offset by lower energy costs.

Economists say higher energy costs next year would pose a risk to the economy. Economist Mark Zandi of Moody's estimates the gap between global production and global demand is only 1.5 million barrels of oil per day. "With such a thin cushion, any substantial geopolitical or weather event could send prices spiraling higher," he writes in an analysis.

In the past, the economy absorbed higher energy prices without much damage. However, Mr. Zandi thinks the next oil price spike could be more difficult to digest. Instead of prices rising because of demand, he cautions they could rise because of shortages of supply "with very different economic implications."

One of the implications, he says, would be inflationary as business passes higher costs on to the consumer. "It is the combination of higher energy prices and interest rates that has undermined past economic expansions," he concludes.

However, even on the future price of oil there is disagreement. Wachovia, for example, expects the price of oil to average $60 a barrel or about where the price is currently. "Falling prices are predicated on OPEC keeping a tight rein on production," says Mr. Schenker. With oil prices at these levels, speculators will shift their attention elsewhere, easing the volatility in prices, he adds.

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