Written by Jeff Thredgold, President, Thredgold Economic Associates
Economic Consultant to Zions Bank

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The U.S. Economy
…more moderate growth
The solid 3.5% real (inflation adjusted) annual growth rate since 2004 should give way to a 2.5%-2.8% real growth pace in 2007. At year-end 2006, the current expansion (which officially began in November 2001) was about to enter its 63rd month. We don’t subscribe to the recession view pushed by some, although odds of a recession have risen slightly.

The Federal Budget
…less red ink
Sharply higher corporate and individual tax receipts reduced the budget deficit for fiscal year (FY) 2006, which ended on September 30, to $248 billion. This compares to the $318 billion shortfall in FY2005 and the record $412 billion shortfall in FY2004. However, budget issues become more challenging in coming years.

Employment
…small business gains
The nation’s unemployment rate averaged 4.6% during 2006’s first 11 months. By comparison, the jobless rate averaged 5.3% in 2004/05 and 5.9% in 2002/03. Monthly job gains have slowed somewhat. We expect the unemployment rate to average just under 5.0% in 2007.

Net job creation via the “official” survey of 375,000 medium- and large-sized businesses has been modest during the past 60 months, with the addition of 5.1 million new jobs. The “other” employment measure, the household survey, has recorded nearly twice as many new jobs, an indication that small business job growth remains strong.

Inflation
…more market friendly
Declines in energy prices have sharply reduced inflation pressures in recent months. For instance? The Consumer Price Index (CPI) from June 2005 to June 2006 rose 4.3%. The 12-month period of October 2005 to October 2006 saw the CPI rise only 1.3%. Overall consumer prices are expected to climb 2.7%-3.2% in 2006. By comparison, consumer prices rose 3.4% in 2005, 3.3% in 2004, and 1.9% in 2003. Most forecasters see 2007 consumer inflation closer to 2.5%.

The Federal Reserve
…on the sidelines
The Federal Reserve has been “on hold” over the past six months, following 17 consecutive 0.25% hikes (to 5.25%) in the critical federal funds rate between June 2004 and June 2006. Prior to that period, the federal funds rate was at a 46-year low of 1.00% for 12 months.

The Fed’s next Open Market Committee (FOMC) meeting is January 30/31, with no change likely. A further move to 5.50% is possible in coming months, although unlikely. Most forecasters expect the Fed to remain on hold through 2007’s first few months, with a move or two (or three) to the downside around mid-year 2007.

Long-Term Interest Rates
…recently trending lower
Mortgage rates were at 10-month lows near 6.125% in recent weeks, before moving slightly higher. Such rates reached 4-year highs in June/July. I would suggest that mortgage rates have peaked for this cycle, with rates possibly moving to “the very high 5s” by mid-year 2007.

The Global Economy
…impressive growth continues
Solid global economic growth is expected in 2007, following impressive growth during the prior four years. Solid growth for 4-5 straight years would be the first such occurrence since the early 1970s. As before, risks to this view include any major new terrorist atrocities (especially on American soil), much higher oil prices, and a worsening of Middle East tensions.

Japan returned to modest economic growth during the past 36 months…following “the lost decade” of economic stagnation. Rising exports to China and stronger consumer spending have benefited the Japanese economy.

Chinese real economic growth has averaged near 9.0% for 26 years, the longest sustained growth for a major nation on record. Of major concern? Powerful economic growth has led to serious environmental damage, with polluted air in major cities and poisoned rivers the norm. A “green movement” in China is underway.

India’s economy continues to perform well, although an infrastructure of two-lane national highways and antiquated airports, sewers, & water systems must be addressed. Most other economies in the Pacific Rim are performing reasonably well.

The European economy has strengthened, with real growth near 2.5%, the best in six years. Kingpins Germany and France still struggle with jobless rates near 10.0% and 9.0%, respectively. The European Central Bank has raised its key short-term interest rate six times since last fall to keep inflation at bay. Additional hikes could occur in 2007.

The Russian economy continues to take advantage of solid oil prices and high oil production, with Russian oil exports now second only to the Saudis. Europeans are leery of interruptions to Russian natural gas supplies this winter as President Putin uses this new “weapon” to his advantage.

The South American economy has slowed somewhat. Oil-rich Venezuela remains a political powder keg, with production now in decline. Venezuela’s Castro-wannabe Chavez will continue to push an anti-America agenda to whoever might listen.

Canadian economic growth has slowed, although the energy-rich Western provinces are booming. Recent unemployment rates in the “low 6s” are at a 30-year low. The Mexican economy is growing at a reasonable clip, with national political tensions at sky-high levels following a bitter presidential election, where both major candidates still claim victory.

The Bottom Line?
U.S. economic growth during the past 36 months has been solid. Stable growth is likely to continue. In addition, we expect: another 12-digit budget imbalance…slowing employment gains…modest inflation pressures…relative stability in both short- and long-term interest rates…and an anxious but impressive global marketplace.

Energy

The U.S. imports roughly 60% of the oil used in this nation every day, a higher share than ever before. One positive aspect of this reality is that the primary sources of oil are more diverse than was the case in the 1970s, which contributed then to the effectiveness of an oil embargo. Still, much of the globe’s oil is under the control of nations who are not friendly to the U.S., including Iran and Venezuela.

Oil prices during much of 2006 were above $60.00 per barrel. Various forecasts of oil moving to $100.00 per barrel and above are prevalent. We continue to suggest that oil prices will eventually settle around $50.00-$65.00 per barrel.

Why? Because the Saudis, still the world’s largest producer of oil, do not want prices sharply higher. Oil prices north of $70.00 per barrel raise the voices of those proposing greater use of natural gas, greater use of coal, greater use of nuclear energy, and greater moves toward energy conservation.

Prices north of $70.00 per barrel enhance the call for more urgent moves toward hybrid and electric cars, clean-burning diesel powered cars, hydrogen cars, and greater utilization of wind, solar, and geothermal sources of energy.

High oil prices raise voices of those proposing greater investment into development of energy-rich oil shale deposits in the Mountain West. High prices enliven discussions regarding all means of reducing the usage of foreign oil and developing oil alternatives.

High prices enhance arguments about the merits of developing oil and natural gas reserves in the Arctic National Wildlife Refuge (ANWR). High prices boost interest in finding and developing promising sources of oil and natural gas off the Continental shelf, as well as making high cost exploration and production in the deep waters of the Gulf of Mexico more financially appealing.

The Saudis do not want us having these discussions. The Saudis are the primary swing player in regard to global oil output. They have and will continue to boost (or limit) oil production with the intent of maintaining prices in the $50.00-$65.00 per barrel range. Such a level is one that both oil producers and oil users can live with, without providing the powerful incentives that much higher prices would in terms of developing oil alternatives.

A shortage of oil is not an issue. Recent estimates have sharply boosted proven and projected reserves of oil.

Different Views
The consumer in me would like to see energy and gasoline prices lower, with more traditional costs near $2.00 per gallon at the fuel pump. The economist in me would love to see prices rise to and stabilize around $100.00 per barrel for three to four years. Such high prices would not likely lead to recession, but would provide the most powerful and most urgent incentives ever for Americans to get a better handle on U.S. sources of energy.

Such high prices would strengthen the American mindset that greater successes in developing alternative sources of energy are available. High prices would provide the incentives to design and implement conservation steps that could be more effective in minimizing energy consumption in all types of appliances.

Renewable sources of energy, including wind, solar, and geothermal, are unlikely to ever provide more than a minor share of overall energy. However, each technological breakthrough in regard to more efficient and more cost-effective solar panels and wind turbines are all part of the solution. Technological enhancements to ethanol fuels (including changes to lessen the massive usage of water for each gallon of ethanol produced), coal liquification and coal gasification, hybrid automobiles, and hydrogen-based cars all contribute to a future less dependent on hostile foreign sources of energy.

What it takes is a nationwide commitment to such a goal. A consensus among government, private companies, and the American people is the first critical step in such a process. Higher energy prices would make that commitment easier.

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