The U.S. economy turned in a strong performance in 2005, overcoming a series of devastating hurricanes and energy price spikes to grow at a 3.8% annualized pace during the first three quarters of the year. Profit growth exceeded expectations, even adjusting companies' reported results for more conservative accounting. Moreover, the monthly data on employment and production suggest continued robust growth in the fourth quarter. This growth performance underscores the underlying resilience of the U.S. economy in the face of adverse shocks.

The economy has benefited from, in corporate terms, easy comparisons. The recession of 2001 and the initially slow recovery left a lot of idle factory capacity and unemployed workers. The economy was able to expand rapidly without pushing up inflation simply by putting those idle resources back to work. The unemployment rate has fallen to 4.9% from 6.3% in mid-2003, and the factory-utilization rate has risen to nearly 80% from 73%. That suggests the economy is using all its available labor and capital, but not straining productive capacity to the point of fueling wage and price acceleration.

The final third quarter GDP report revealed that domestic demand was slightly weaker than previously estimated while inflation was slightly stronger. Real GDP growth was revised to 4.1% (from a 4.3% preliminary estimate). The downward revision to real GDP reflected weaker spending growth on durable goods, primarily motor vehicles. There were also small downward revisions to business and residential investment and government purchases.

Nonfarm payrolls rose by a disappointing 108,000 in December (vs. a consensus forecast of +210,000). However, November's gain was revised sharply higher (to +305,000 from +215,000). Furthermore, seasonal adjustment uncertainty makes the December result somewhat suspect. The unemployment rate edged down to 4.9%, but it remains unclear at this point how tight labor market conditions really are.

Headline inflation accelerated in 2005, reaching its fastest pace since 1991, as crude oil prices continued their multi-year climb and refined energy prices spiked with the Gulf hurricanes. The overall CPI rose an estimated 3.8% in 2005, the highest since 1990.

Core inflation was fairly steady in 2005. Core CPI rose an estimated 2.1%, while the core chain PCE price index, the Fed's favorite price measure, rose an estimated 1.8% in 2005. Nonetheless core PCE inflation has continued to run in the upper portion of the Fed's comfort zone on a year- over-year basis in recent months. With the labor market continuing to firm, and energy and other commodity prices up significantly on the year, core inflation could edge higher over the next few quarters, slightly breaching the upper limit of the Fed's comfort zone.

November data on producer prices contained more signs of pipeline price pressure, as the core intermediate index rose 0.5% on top of two consecutive 1.2% surges. However, finished goods price trends remain in check, with the core PPI up only 0.1%. The November core PCE price index also increased a less-than-expected 0.1%. The degree of pass-through from energy-related pipeline price pressures to finished goods prices has been negligible thus far.

The December ISM report points to slower, though still solid, expansion in manufacturing conditions. It also suggests that price pressures, while still elevated, are rising more slowly.

The ISM Manufacturing Index fell to 54.2 in December, vs. 58.1 in November, consistent with mixed-but moderate growth in the factory sector. New orders, production, and employment continued to advance, but at a somewhat slower pace. Input price pressures remained relatively high, but are receding.

The ISM Non-Manufacturing Index rose to 59.8 in December, vs. 58.5 in November, consistent with moderately strong growth in the overall economy. New orders and employment continued to advance. Input price pressures remained high, but were less severe.

The Conference Board's index of consumer confidence fell to a two-year low in October in the aftermath of the hurricanes and subsequent spike in energy prices. However with gasoline prices dropping and continued labor market improvement, the index rebounded sharply in November. Consumer confidence rose further to 103.6 in December, led largely by increased optimism about current labor market conditions.

The final University of Michigan consumer sentiment index was revised higher in December to 91.5 from the preliminary reading of 88.7. This represents the highest sentiment reading since July 2005's 96.5 print and gets us back to the pre-Hurricane levels. The University of Michigan long-term inflation expectations measure (5-10 years) was revised slightly higher to 3.1% from 3.0% in the preliminary estimate. The one-year-ahead inflation expectations measure held steady at 3.1%.

Consumer spending grew at a strong 4.3% annual rate in the third quarter as deep discounting by U.S. auto manufacturers produced a surge in sales over the summer. Spending weakened when mid-year incentive-driven vehicle sales fell off and sharply higher energy costs temporarily restrained real spending, but steady employment gains, reflecting improving business confidence late in the fourth year of expansion, and a rapid reversal of gasoline prices improved consumer confidence and supported a moderate holiday season.

On the energy price front, gasoline prices have dropped off significantly. Over the past few months evidence has mounted that those high prices are beginning to moderate the demand for oil. Prices have already fallen back substantially from their peaks in September. If they were to fall further, global growth could be somewhat stronger than expected. Natural gas prices are projected to peak over the winter and then recede.

First Quarter Outlook

The US economy has been expanding at moderately-above-trend rates with core inflation still contained in the second half of 2005. Despite higher energy prices and other adversities, the notion of a sustainable economic expansion in the U.S. remains intact, with real GDP growth expected in the 3.5% range in 2006. Income growth and solid job creation should counteract higher energy prices, interest rates, and diminishing equity extraction in sustaining consumer spending, although at slower pace. Meanwhile, business spending on capital equipment and inventory rebuilding as well as disaster reconstruction spending should pick up any slack from a potential consumer slowdown. Housing market activity has likely peaked, and price appreciation is expected to moderate.

Therefore financial markets are entering 2006 in a general state of complacency. Fixed-income, equity, and foreign exchange volatilities remain near multi-year lows. Risk premia, as represented by credit spreads, are tight in most asset classes. Interest rates are at historically low levels, and the yield curve is virtually flat. The factors responsible for current market conditions are well-understood. Low inflation and transparent monetary policy have led to a decline in volatility and greater appetite for financial risk.

Nonetheless there are plenty of unknowns going into the New Year, and that is one reason some analysts warn investors to prepare for sharper ups and downs than they have seen lately. Some of these uncertainties include how strong profits will be, whether the economy will continue to boom, whether inflation will return, what oil prices will do, how the midterm Congressional elections will affect stocks and how much longer the Federal Reserve will continue raising interest rates.

Consumer spending growth is expected to moderate during 2006, in response to increased monetary restraint, higher interest rates, and softer housing and mortgage financing, but there will be healthy offsets from other sectors. Fluctuations in energy costs and swings in vehicle sales may contribute to considerable quarter-to-quarter variability in spending.

Healthy growth in exports, robust business capital spending and moderate inventory rebuilding will support the economy, along with government outlays related to rebuilding in the Gulf. Corporate profits should continue to grow, as productivity gains largely offset cost increases.

Global economic growth should remain adequate, with the U.S. leading other developed economies in terms of real GDP growth. Large budget and current account deficits are expected to persist.

Foreign investors should continue plowing the U.S. current account deficit back into U.S. debt, and the long end of the curve looks unlikely to stray by more than 25 to 50 basis points (bps) from today's levels.

The Fed has continued steadily on its measured pace of raising rates and it shows every sign of remaining on this track in the near term. But broad financial conditions have not tightened appreciably since the Fed began its measured pace of tightening in mid-2004. Of course, it is well known that monetary policy affects the economy with a lag, and credit conditions are likely to become more restrictive in the second half of the year.

The Fed has helped stabilize interest rate markets with particular effectiveness in the last two years, and a Bernanke Fed undoubtedly will try to push that further. Transparency and a focus on price stability have become hallmarks, and those features stand to define Fed policy under Bernanke more sharply than ever.

The future path of core inflation remains one of the key drivers of monetary policy expectations beyond the 4.50-4.75% Fed funds target rate. After moderating for a number of months earlier this year, core consumer price inflation has been accelerating again most recently. The jump in energy prices this year and tightening labor and product markets could be reflected in a modestly higher rate of core consumer price inflation over the next couple of quarters, moving core inflation slightly above the Fed's 1-2% comfort zone.

Bernanke will most likely be inheriting from Greenspan an economy that is in the process of landing softly, with output near potential, growth near trend, and inflation close to the desired range. However there are several key risks to our central soft landing scenario for the year ahead.

First, the housing market and consumer spending may soften more than expected. Consumers could slow their spending substantially more than predicted if home price inflation were to drop off more sharply in response to higher interest rates and an unwinding of speculative excesses. This could spill over into businesses spending and hiring, leading to a self-reinforcing slowdown.

Second, if the recent gains in labor cost inflation and energy costs were passed through to core consumer price inflation more aggressively than projected, the Fed could soon find itself behind the curve on its inflation objective. In this case, it would shift to a more aggressive path of rate hikes, and the bond market would sell off substantially more than expected. These developments could in turn lead to significant declines in both home prices and stock prices, setting the stage for a substantial slowdown or possible recession in 2007.

Third, the dollar could plunge. Little progress is likely to be made in narrowing the U.S. budget and external imbalances. With the dollar having risen over the past year, the external deficit is likely to resume widening over the year ahead, and post-hurricane rebuilding expenses are likely to help keep the Federal budget well in the red. If the global appetite for U.S. assets does not continue to grow, the result will be potentially significant upward pressure on U.S. interest rates and downward pressure on the dollar.

Several factors suggest that any slowing in expansion will be brief and mild. Fiscal policy will provide a modest lift to activity, reflecting aid to hurricane-damaged areas. In the absence of a serious inflation problem, the Fed does not have to risk a sharp tilt toward restrictive policy.

In fact if the Fed gets its way next year, long-run inflation expectations will fall far enough to allow an end to rate hikes by June. Those expectations will hinge on Fed success in its current inflation fight, as well as it's commitment to future fights. If the economy slows, the Fed will probably hesitate to ease unless inflation expectations signal concerns about deflation.

While U.S. interest rates are low, they are still higher than in many countries. Governments with dollar surpluses like to buy the widely traded 10-year notes (two-year notes are less widely demanded by foreigners) and demand for 10-year notes pushes down their yields.

Amid 200 bps of Fed tightening in 2005, bond yields rose modestly and the yield curve flattened considerably. We expect further flattening as the Fed raises rates early in 2006, while bond yields are anchored by the Fed's inflation-fighting credibility. A mildly inverted yield curve is likely.

The possibility of an inverted Treasury yield curve has generated anxiety about a possible recession later this year. While the yield curve is a strong leading indicator of the economy, it is not foolproof. A flat curve is consistent with slower economic growth. A truly inverted curve (a 10-year Treasury yield to Fed funds rate of -100bps) signals that a recession is likely. Currently, the curve is flat, not inverted, and any inversion should be mild and not of the magnitude to predict a recession.

A yield curve inversion, if it occurs, is likely to be due to supply-and-demand factors, rather than an over-restrictive monetary policy. "Structural" supply and demand factors - including foreign "savings glut," currency exchange regimes, and pension plans have compressed long-term interest rates. Thus, an inverted yield curve need not imply an impending recession.

Witness that over the past few quarters the economy has shown considerable resilience in the face of high energy prices and the disruptions of the hurricanes. Some signs of increased inflation risk have also emerged. The challenge for the Federal Reserve now is to ease the economy back to trend to contain emerging inflationary pressures. We think that the Fed will have to continue raising short-term interest rates to achieve this objective.

The U.S. economy is likely to retain plenty of the momentum built up in the second half of 2005 as it enters 2006, but growth in the second half of the year is predicted to slacken as an anticipated weakening in housing saps some of the economy's strength.

First half GDP growth will reflect still solid consumer spending as households respond to rising real after tax incomes (from falling energy prices) and additional housing market turnover.

In the first half of 2006, job growth should remain strong as firms face little or no remaining labor market slack from the 2001 recession. Strong corporate balance sheets loaded with cash and sharply lower levels of short-term debt are expected to stimulate business spending. Finally, government spending, which as of late 2005 showed little sign of pause, is projected to remain robust in 2006 as money is spent on rebuilding the Gulf Coast.

After two and a half years of sustained 4% growth, the U.S. economic expansion likely will moderate in the second half of 2006. GDP growth is expected to cool off in 2006 as the stimulus from rising home prices fades. Wage and commodity price pass-through will probably cause core inflation to creep higher.

The last crucial hurdle to clear the end of the interest-rate cycle is evidence that upside inflation risks have been safely offset. Core inflation at 2% is already at or near the top of FOMC officials' comfort zone and it may well drift into a 2.0% to 2.5% range at its cyclical top in 2006. That uptick need not tie the Fed's hands if they are satisfied - as in 1995 and 2000 - that the forecast for inflation beyond that is improving.

As 2006 unfolds, the resilience and continued good economic fundamentals of the U.S. economy stand out, including solid productivity gains, flexible labor and capital markets, and low inflation and inflationary expectations.

Firmer monetary policy, with a flatter yield curve and higher real interest rates, a deceleration in real estate valuations and a decline in mortgage refinancing will restrain consumer spending below recent years' trend growth.

Summary