When making its monetary policy decisions, however, the Federal Reserve takes into consideration not only the outlook for economic growth, but also the outlook for inflation. In the past two years, the inflation rate has moved up, thanks in large part to a spike in energy prices. But inflation, unlike housing, is a lagging economic process, and with growth in the aggregate demand slowing and expected to remain subdued in 2007, the rate of inflation also would be expected to pull back, as well. In fact, it already has. With energy prices off their cyclical highs, various measures of consumer inflation appear to have peaked on a year-over-year basis back in September 2005.

Still, the Fed has indicated that its policy decisions are geared more toward containing the so-called core rate of inflation–that is, the rate of inflation excluding the more volatile energy and food price components. One factor that has played an important role in putting upward pressure on core inflation of late has been the rent of shelter–the explicit rent on dwellings, as well as the imputed rent on owner-occupied dwellings. Rent of shelter tends to rise at a faster pace as the purchase of homes becomes less affordable because more people are forced into the rental market. In a sense, then, past Fed interest rate hikes, by making home purchases less affordable, have contributed to the rise in core inflation. The six-month percent change in the index of Leading Economic Indicators (LEI) is a reliable guide to both the cyclical behavior of the economy and the Fed's interest rate policy. In the past, when the LEI has started to contract, the Fed has switched from raising its interests rate policy to cutting it (see chart above). With the LEI now contracting, I expect the Fed to begin cutting interest rates in the first quarter of 2007.

FEAR NOT. PROFITS WON'T TANK By MILTON EZRATI
Though for years now the investment environment has received support from robust earnings growth, the pattern is clearly beginning to change. Between 2002 and early 2006, well-contained labor costs boosted corporate profits above consensus expectations at every turn, frequently by wide margins. But the maturing economic expansion should see at least a moderate rise in labor costs, detracting from profits accordingly. Overall earnings should continue to expand in 2007, but undoubtedly at a much reduced pace from recent experience.

So far in this expansion, earnings have followed a remarkable growth path, always surprising on the high side. Back in 2002, when the Wall Street consensus could not even agree whether the economy would grow, the reported profits of the companies in the S&P 500 stock price index rose by almost 12%. Though in the intervening years Wall Street continued with its restrained earnings expectations, reported profits soared, rising at an average annual rate of 36% between 2002 and 2005. So far this year, earnings seem on track to deliver growth between 12% and 13%.

Contained labor costs account for much of this impressive profits growth. Though wages expanded 4% to 4.5% a year during this time, a productivity surge more than offset the cost burden on business. Output per hour between 2002 and 2005 grew at almost a 4% annual rate, double its historic rate of advance and so close to wage hikes that the labor cost of producing a unit of output actually fell slightly. In that cost climate, any price increases businesses could get went directly to the bottom line, pushing up economy-wide profit margins on sales from 2.5% in 2002 to 12.5% in early 2006.

But this highly favorable pattern seems set to change going forward. If history is any guide, productivity growth will slow and unit labor costs will rise as the economic expansion matures. Signs of this change have already begun to emerge. During the last six months, output per hour has expanded at under a 1.0% annual rate, less than one-quarter its previous rate of gain. Since, at the same time, the relatively tight labor market has added marginally to wage growth, the cost to businesses of producing a unit of output has begun to rise. The most recent measures show unit labor costs rising at about a 4.6% annual rate during this time. Since these patterns are likely to persist, profit margins should suffer going forward into 2007, especially because businesses will not likely get offsetting price increases.

The change will not likely go far enough to shut down the profits expansion altogether, especially since ongoing economic growth will continue to lift sales volumes. But the margins erosion should slow the pace of profits growth. Calculations of this sort are always slippery, but preliminary figures suggest earnings growth in the high single-digit range, around 7% to 8% in 2007. That growth is still healthy enough to support a continued corporate expansion and equity prices, but a big change nonetheless from the remarkable positive earnings surprises of the past few years.

MATERIALISM WILL SAVE THE DAY By STEPHEN STANLEY
Consumer spending has been buffeted over the past few years by a myriad of influences. From 2001 to 2003, income gains were tepid, but household finances were sustained by accommodative fiscal and monetary policy–tax cuts and low interest rates (which led to a mortgage refinancing boom). Once the economy finally began to generate solid job and income growth in 2004, households were faced with a substantial drag from surging energy prices. At the same time, rapid home appreciation made many households wealthier, which undoubtedly generated extra spending. Of course, it is impossible to disentangle and quantify precisely the various influences on consumer spending, but it is critical to the economic outlook to have a rough idea of how these forces have netted out in the past and how they will impact consumer demand going forward.

Economists have studied the so-called "wealth effect" for years, and a consensus of numerous studies finds that households spend roughly a nickel upfront for every dollar of wealth gain that they enjoy. This relationship would imply that the rapid home price appreciation in 2004 and 2005 added roughly $100 billion and $115 billion, respectively, to real consumer spending (between 1.25 and 1.5 percentage points to the real growth rate in each year). Slower price gains in 2006 may have lopped this past year's boost by close to half. Likely, there will be little or no upward wealth effect from home values in 2007 nationally.

Can consumer spending avoid weakening dramatically without the boost from historically outsized home price gains? The answer should be yes as long as income gains hold up. In 2004 and 2005, wage and salary income grew by 5.5% and 5%, respectively. This year, labor income accelerated, probably to around a 6.5% gain. Will employment and wage growth continue at the 2006 pace in the coming year, slow somewhat, or collapse? I believe that income gains will cool from the robust 2006 pace, reflecting somewhat slower job growth (as manufacturers and home builders may shrink their workforces while most other sectors should continue to add jobs) but remain similar to the pace seen in 2004 and 2005.

At the same time, energy prices, which have been a significant drag over the past three years, could (emphasizing could, because no one really knows where oil prices are headed) flatten out in 2007. If so, then the removal of the drag from energy costs will also provide a counterweight to the removal of the boost coming from housing wealth gains.

Netting out these three factors suggests that consumer spending growth will probably slow in 2007, but to a still-decent clip. Over the past three years, consumer outlays in real terms have risen at a 3.5% annual pace, somewhat above the economy's presumed long-run speed limit of 3%. In 2007, consumer spending may cool to a 2.5% rate, slower to be sure but not so weak as to spark an economic downturn. Under that scenario, economic growth should gradually accelerate as declines in residential construction wane, returning to a healthy clip by the second half of the year.