If Ben Bernanke becomes the next chairman of the Federal Reserve Board in February as expected, his main concern will be helping to guide the U.S. economy to the soft landing triggered by the rate hikes started in 2004. Most economists expect that 2006 will be another overall strong year of growth, especially in the first half, and that the Fed will gradually take the fed funds rate closer to 5%.
But whether the landing is soft or hit by turbulence will depend on several challenges that will make the Fed's job more difficult. "The economy is still undergoing a transition from an above trend growth to a trend rate of between 3.2% and 3.4%, so it becomes trickier next year for the Fed," says Randell Moore, editor of the Blue Chip Economic Indicators. The consensus of 53 economists tracked by Blue Chip expects real GDP growth of 3.6% in 2005 and 3.4% in 2006, a sign of general confidence in the year ahead, although growth is expected to cool in the third and fourth quarters.
Perhaps the worst case scenario would involve a sharp spike in long-term interest rates that could move the economy closer to a recession in 2007. Although the yield on the 10-year Treasury note has risen by about 100 basis points in the last two years, its current yield at around 4.5% remains tepid, and a sharp spike remains a remote possibility in the near term. But with rates on the rise in Europe, investors may find other places to put their cash. "Ben Bernanke is a risk factor," says John Lonski, chief economist at Moody's Investors Service, referring to the perceptions about what the next Fed chairman will do. "It's a change in leadership at the Fed that might reduce the willingness of foreigners to lend to the U.S." Although regarded as a fundamental inflation fighter in the Greenspan mold, Bernanke is an unknown when it comes to his communication skills and ability to manage in times of crisis–two jobs at which his predecessor excelled. "The biggest risk for the marketplace is that [Bernanke] will do what new guys do–over-tighten to prove he's tough on inflation," says Cary Leahey, senior managing director at Decision Economics in New York. Leahey notes, however, that the pressure on Bernanke to hike has been reduced after the Federal Open Market Committee decided in December to withdraw accommodation language that predisposed it to more rate incresaes.
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A sharp rise in long-term rates could create havoc in the housing markets, but even less dramatic changes could make 2006 tougher going than the last several years. One key will be the direction of consumer spending, which many believe is due for a softening. Spending by individuals has continued to be strong in recent years, growing at 3.8% in real terms in 2004. But some erosion was noticeable in 2005 when consumer spending is supposed to grow at a slower 3%, thanks to a somewhat limp fourth quarter. Spending is likely to contract further in 2006 as higher energy costs continue to eat at budgets and housing demand cools as mortgage rates tick higher. "I don't see how consumers can keep running at this pace," says David Wyss, chief economist at Standard & Poor's Corp. Slower consumer outlays could be a big hit to the most sensitive sectors like retail, automotive and producers of big-ticket appliances. Decision Economics' Leahey expects spending to be flat at 3% in 2006, but says it could be closer to 2.5% if a sharp slowdown in housing activity brings durable purchases down with it. Even at that level, the economic impact would be a reduction in GDP by as much as half a percentage point, according to Leahey, a huge shift, but perhaps one that is offset by other areas.
More and more economists see a growing risk of sharp house price declines. S&P's Wyss estimates that the ratio of housing prices to incomes is 20% above the historical average, and closer to 40% above average in some large metropolitan areas. U.S. homes, he says, are selling on average for 3.2 times average household income, compared with a historical average from the last 45 years of 2.6 times. Wyss sees the chances of a national housing collapse as small, however. "The most likely case is housing prices nationally level out, but you have to worry about those that have appreciated the most, mainly on the coasts," he says. "If there is a sharp spike in interest rates, they could fall faster."
A SEA OF GREEN–AND PERHAPS RED
One reason that most economists don't expect lower consumer spending to hit the economy hard in 2006 is that other factors, particularly the corporate sector, remain strong. "[The Fed is] going slowly, trying to put a damper on real estate and the consumer, to rein in the excess without rolling the economy into recession," says Chip Hanlon, president of investment advisory firm Delta Global Advisors. "But the further we go along, it seems like corporate balance sheets are so strong [that] Corporate America can pick up the baton, perhaps in stronger IT spending or job growth." As 2006 begins, companies are still rolling in more cash than they know what to do with. But if productivity rates slow, they may be forced to expand investments in new operations and equipment. So far, the answer for cash cows has involved returning money to shareholders in record amounts, and according to the latest data the trend is getting stronger. S&P estimates that among S&P 500 companies, share buybacks for the first three quarters of 2005 exceeded the previous record of $228 billion in all of 2004, and for the full year the figure could exceed $300 billion.
But the corporate sector is not immune to the current pressures on the economy, either, and concerns over oil prices, large federal deficits, rising rates and the shadowy prospect of more inflation are evident in Treasury & Risk Management's latest economic confidence survey of CFOs, treasurers and controllers. Nearly half the 354 respondents said they believed the economy would be "growing but losing steam" during the next four quarters, and another 31% saw more negative pressures than positive. Which economic scenario Bernanke buys into is still somewhat unclear, but as the new guy at the Fed, he risks becoming a factor in any slowdown if he oversteers.
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