U.S. economic forecast for 2007: Cooling off but no recession

The economy will cool off because of a slowing housing market and rising energy prices but will experience a soft adjustment and modest growth in 2007, according to John B. Taylor and Peter Wall, two speakers at the 43rd Annual Economic Forecast Luncheon, co-sponsored Dec. 6 in Phoenix by the W. P. Carey School's Department of Economics and Chase.

The economy will cool off because of a slowing housing market and rising energy prices but will experience a soft adjustment and modest growth in 2007, according to two speakers at the 43rd Annual Economic Forecast Luncheon, co-sponsored Dec. 6 in Phoenix by the W. P. Carey School's Department of Economics and Chase.

Stanford economics professor John B. Taylor, senior fellow at the Hoover Institution, expects the United States' growth in gross domestic product to be 3 percent, down from 3.2 percent in 2005 and 3.9 percent in 2004. Peter Wall, JPMorgan Chase's chief investment officer for private client services, foresees U.S. growth falling to "around 2 percent" as the nation avoids a recession.

Midpoint in "The Long Boom"

"The United States economy just marked the five-year point in its current economic expansion," Taylor said. "It started back in November 2001 just after the 9/11 terrorist attacks and the 2001 recession, which was brought on by the sharp stock market drop and tight financial conditions in 2000. This expansion — the first of the 21st century — is already the third-longest expansion in United States history, excluding periods of major mobilizations such as during World Wars I and II."

Taylor coined the label "The Long Boom" about 10 years ago when he noticed a pattern of shorter, milder and less frequent recessions after the expansions in the 1980s and 1990s, respectively the second-longest and longest expansions in U.S. history. "When you splice these three recent expansions together with the two short recessions in between you have a truly phenomenal and certainly unprecedented period of stability and growth," Taylor said.

"The Long Boom began with the end of the severe recession that ended in November 1982, so it has just entered its 25th year. Since it began, 46 million jobs have been added to U.S. payrolls and the Dow Jones Industrial Average has gone from under 1,000 to over 12,000." Taylor is not alone in expecting that "Long Boom" in the economy to continue, but at a slower pace. The official government GDP forecast for 2007 recently was reduced from 3.4 percent to 3.1 percent.

The surprise of 2007

According to Wall, "the surprise of 2007" will be that "the U.S. slows, and the rest of the world doesn't." Wall said that while U.S. profits will grow 6-8 percent with equity markets up 8-9 percent, returns will be slightly higher in Europe and Japan, where the pace of earnings and cash flow is on the rise. Wall predicts high single-digit returns for diversified hedge fund and commercial real estate portfolios.

"Merger mania continues, with corporate cash balances higher than any time in the last 50 years," Wall said. Wall advised investors to hedge risk, to diversify with a greater allocation into international equity and to buy into sustainable growth in the health-care, consumer staples and technology sectors. "In the United States, substantial benefits of value and small-cap tilts have likely run their course," Wall said.

Oil and real estate

In recent interviews, Taylor and Wall said the housing market and petroleum prices are key concerns, although the economy grew in 2006 despite rising oil costs and a softening of home prices. "There has been a marked slowdown in housing starts," Taylor said. "In the 'Monday morning quarterbacking' sense, you could say interest rates were kept too low in late 2002, 2003 and early 2004," leading to somewhat artificially high housing prices.

He said he expects the decline in the housing market to be gradual enough not to shock the economy. Besides, he said, the correction in the housing boom will benefit home buyers and make it easier for employers to recruit employees. "I think the reduction in GDP forecast is due to forecasters still getting their arms around the magnitude of the housing market decline in the U.S. and its ripple effect — construction job loss, consumer durable spending, etc.," Wall said.

Should more be done to develop alternative energy and reduce price shocks to the economy? "We need to take policy efforts to reduce demand and to create alternative energy sources," Taylor said. "Energy dependency has both political and economic ramifications so, clearly, the answer is yes," Wall said. "Domestically based alternative, renewable energy sources will reduce the trade deficit, create new technologies and new jobs, reduce inflationary pressures and increase the potential for long-term economic growth."

Inflated pessimism?

Taylor and Wall are disappointed that people are not more optimistic about the economy. According to the American Research Group, 15 percent of Americans said in November 2006 that the national economy is getting better, 37 percent said it is staying the same, and 44 percent said it is getting worse. Four percent were undecided.

Six months before, in May 2006, 26 percent of Americans said that the national economy was getting better, 14 said it was staying the same, and 59 said it was getting worse. One percent of those polled were undecided. "Among Republicans, 68 percent approve of the way President Bush is handling the economy and 27 percent disapprove," the American Research Group states.

"Among Democrats, 85 percent disapprove of the way Bush is handling the economy and 12 percent approve. Among Independents, 22 percent approve and 72 percent disapprove of the way Bush is handling the economy." It's interesting to note that six months ago, more people said it was getting worse and more people said it was getting better. Taylor said that annual growth in the late 1970s and early 1980s was only about 1 percent and that growth has been more robust and recessions less severe since then.

Taylor cites five years of growth since the last recession and said he is encouraged by the unemployment rate of 4.4 percent. He said 9 million jobs have been created since the recession ended in November 2001 and that 8 million were created between the end of the recession in March 1991 and March 1996. "I think it's quite comparable," he said of the job numbers. "The jobless-recovery concept is obsolete."

Taylor admits to being puzzled by what he sees as undue pessimism about the economy in national polls. "Twenty-five percent of people in the polls think we're in a recession," Taylor said. He said that since the double-digit unemployment and inflation of the late 1970s and early 1980s, "People have gotten used to this rather good, stable economy."

Still, according to Pew Research, about 50 percent of adults say that today's children will end up worse off economically than people are now. About 34 percent say that they will be better off and most of the rest are not sure. In 1999, 55 percent believed that children would grow up to be better off than their parents, and 36 percent said they would be worse off.

Taylor said people should appreciate the stabilizing role that stricter monetary policy has brought about since the 1982 recession ended. He said he is encouraged by the reduction in the federal budget deficit to about $260 billion in 2006, compared with $319 billion in 2005 and the 2004 all-time record of $413 billion. "The decline in the deficit is because of the expansion," he said, also stating, "If the deficit had not increased in 2001 and 2002, the recession would have been a lot worse." The United States' other deficit, its record trade deficit, will decrease in 2007, Taylor predicts.

"Exports will be stronger in 2007," he said. "I think the trade deficit will be lower, not a lot lower, though. It's not going to happen fast." He said the negative U.S. savings rate must be addressed. "The trade deficit reflects the fact the U.S. economy has been expanding faster than our trade partners'," Taylor said. "The trick here would be to increase the savings rate and buy less foreign goods."

Lack of real wage growth equals lack of optimism

Wall cites several reasons for the lack of optimism: lack of real wage growth, increasing health care costs and job insecurity. "For most of the five-year expansion that we have been in, real wages have been negative," Wall said. 'It's only in the last few quarters that we have seen real wage gains.

Unfortunately, this is occurring at a time when American companies are asking their employees to assume a larger share of health-care costs. Finally, outsourcing — perceived or real — has taken a psychological toll on American workers. There is a fear in blue- and white-collar employees that their jobs could be transferred to China, India, Ireland." Wall said job numbers have been generally good and that the bulk of the newly created jobs are of good quality.

"I think that has provided support for consumer spending, and certainly people's fears about job insecurity and lack of real wage growth haven't discouraged them from going to the mall," Wall said. "Sometimes, actions belie concerns, and this may be one of those instances."

The remedy to job-light recovery is hard to pinpoint. "With globalization, job-light recoveries — vs. historical standards — may be the norm," Wall said. "We may be entering a long-term era of slower economic growth in the U.S. due in large part to emerging economies with growing manufacturing and service sectors and the reality of American demographics. The U.S. population is aging, as is Europe and Japan, and economic output is still dependent on the size and quality of the labor pool."

Effect of monetary policy

Taylor and Wall said they believe the cooling off of inflation during the 1980s can be attributed to stricter monetary policy more so than to the leveling off of OPEC oil prices. Taylor sees a cause and effect between monetary policy and his "Long Boom" observations. Wall agrees. "Paul Volker came in with a very specific mandate and he used monetary policy very effectively to reduce inflation," Wall said.

"We had a pretty severe recession in the process but it was the Fed's use of monetary policy, aggressively raising Fed funds and discount rates, that was the primary tool. As a result, the Fed's credibility — the Volker-Greenspan era — as a capable inflation fighter was established." Still, oil prices are unlikely to do anything but rise in the long term as demand increases and easily pumped oilfields are drained, a phenomenon known as "Peak Oil."

"Expected growth rates in emerging economies such as China, India, Brazil would indicate that oil prices should continue to rise," Wall said. "These countries and many other emerging economies are still well below their projected peak energy consumption levels — based on the consumption levels of developed economies — so growth in energy demand is expected to outpace growth in supply. That doesn't mean we won't see intermittent declines in oil prices."

Bottom Line:

• Growth will be slower in 2007, but there should not be a recession.
• Although globalization has hampered job growth and job quality, improved stabilization of the economy is cause for optimism.
• Investors should hedge and internationalize their portfolios.
• The cooling of the housing market does not mean it will collapse; besides, lower prices will help home buyers and aid employee recruitment.
• The United States needs to develop alternative, renewable, domestic energy sources to ensure long-term economic health and to minimize short-term shocks cause by fossil-fuel prices.