IT’S A GROWTH STORY (AGAIN)

Today’s fourth-quarter report on GDP reminds that pessimism is a risky sport when it comes to forecasting America’s economic outlook.
Annualized real GDP grew by 3.5% at an annual rate in the last three months of 2006, the government reported this morning. The pace was surprisingly strong for Mr. Market and the legions of dismal scientists who watch the economy for a living. The consensus prediction called for 3.0% growth, according to TheStreet.com.
Expected or not, 3.5% growth is impressive. That’s the fastest pace since the red-hot rise of 5.6% in 2006’s first quarter. More importantly, the 3.5% pace of 4Q 2006 came in a quarter that was widely said to be marred by the real estate correction. So said Larry Kantor, a managing director and co-head of research at Barclays Capital, in New York this morning. Your editor just happened to be at a press conference at the firm this morning when the GDP news arrived. Reflecting on the update, Kantor said that the drag on the economy in the recent past was hardly devastating.


What’s more, Kantor predicted that the housing correction, such as it is, will fade as an impediment to the U.S. economy in 2007. As he put it, the economy will “reaccelerate” this year. The housing market doesn’t need to impress to see a stronger economy. Rather, housing merely has to flat line, he said. And since housing prices have already fallen, that implies that the real estate market looks likely to hold steady if not post mild growth.
Overall, it’s hard to argue. The fourth-quarter GDP increase strongly suggests that upward momentum in growth has returned. The idea that a recession is lurking just around the corner is all but dead in the wake of today’s news. The implications are many, starting with the revised thinking that now weigh on the Federal Reserve.
You may recall that Fed Chairman Ben Bernanke argued last year that the expected slowdown in the economy would take the edge off the uptick in core inflation of late. The Fed is widely reported to have a “comfort zone” of 1-2% for core inflation. Alas, that comfort zone has been breached recently, with core inflation reaching an annual rate of 2.9% last September, up from 2.0% a year earlier. The pace has come down a bit, with core inflation running at 2.6% as of December 2006. But with today’s GDP report, it seems prudent to wonder if the economy will moderate enough to push core inflation lower, and thereby head off a fresh round of rate hikes.
As we write, the FOMC has yet to announce its interest-rate decision scheduled for this afternoon. But whatever comes, the markets will now be looking for some recognition that the central bank is prepared to deal with the stronger-than-expected economic growth. Reading the tea leaves of the FOMC statement will take on that much more significance.
The good news is that the employment cost index grew by only 0.8% in the fourth quarter, down from 1.0% in the third quarter. “The moderate growth in the ECI holds little evidence that a tightening labor market will exert wage-induced pressures on inflation,” David Resler, chief economist at Nomura Securities in New York, wrote in a note to clients this morning.
As for the surprisingly strong economy, that’s the story to watch, and it may color economic reports for some time. If the markets have been willing to give the Fed the benefit of the doubt before, we expect deterioration in the inclination going forward. Ben may need to prove himself all over again in 2007.

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