Economic Cycle Analysis February 27, 2007

The Economy A panel of 60 economists who participated in the WSJ's latest semiannual economic forecasting survey offered an optimistic outlook for 2007: The service sector should keep humming along as the recent weakness in housing and manufacturing abates and the Federal Reserve begins to reduce interest rates. That would allow the economy to expand at a rate fast enough to keep investors happy, but slow enough to keep inflation at bay.

The Economy The world's central bankers are so confident that growth will remain steady and inflation under control that their main worry is less the immediate future than whether conditions are breeding excessive speculation in financial markets Indeed, though the U.S. economy has slowed substantially from its torrid pace of a year ago, it has kept growing fast enough to keep unemployment down despite the housing slump Central bankers' latest concern is that investors are underpricing risk, and bidding up prices of assets from corporate bonds to houses and in the process driving down returns on those assets, such as long-term interest rates.

The Economy Globally, inflation is still low by recent historical standards, though higher than some central bankers would prefer. U.S. consumer prices, excluding food and energy, rose 2.7% over the past 12 months Core inflation, now running at a 2.2% rate by the Fed's preferred measure, remains higher than the 2% ceiling most Fed officials are comfortable with Oil prices are still down to where they were this time last year Global stock markets are buoyant Demand remains strong both home and abroad Profits are still making healthy gains Corporate balance sheets are in great shape

The Economy Outside of the housing slump, demand in 95% of all spending categories was up 4.4% from a year ago, the fastest annual advance in almost 7 years Excluding the energy sections, profits in the remaining 9 sectors of the S&P 500, are up 14.5%

GDP The U.S. economy rebounded at the end of the year as GDP grew at a faster-than-expected 3.5% annual rate in the fourth quarter, surpassing even economists' raised forecasts3.5% annual rate Consumer spending picked up amid lower gasoline prices, and a price inflation gauge posted its sharpest drop in 52 year For all of 2006, GDP advanced 3.4%, compared to a 3.2% increase in 2005.

Federal Reserve Fed officials generally don't see market speculation as a reason to tighten monetary policy, or even keep it tight They have cited the lack of spare economic capacity and an elevated inflation rate as a reason to maintain short-term interest rates at 5.25%, with a bias to raising them further An accompanying statement, meanwhile, was upbeat on the outlook for "moderate" economic growth and lower inflation, suggesting the Fed is quite comfortable with rates where they stand.

Federal Reserve For decades, a simple rule has governed how the Federal Reserve views the nation's economy: When unemployment falls too low, inflation goes up, and vice versa. Fed officials have rethought that notion. They believe it takes a far bigger change in unemployment to affect inflation today than it did 25 years ago. Now, when inflation fluctuates, they are far more likely to blame temporary factors, such as changes in oil prices or rents, than a change in the jobless rate. That's one reason the Fed, though it expects core inflation to ease this year, isn't relaxing. With unemployment currently 4.6%, at or below the Fed's view of its natural rate, inflation may edge up after the temporary impacts of energy and rent subside. That could require the Fed to raise interest rates enough to push unemployment up sharply and bring inflation down.

Unemployment The number of workers filing new claims for unemployment benefits fell sharply last week as the effect of recent winter storms appeared to dissipate, but claims levels nonetheless remained above levels seen late last year, suggesting some slackening in labor markets. New claims for unemployment insurance fell by 27,000 to a seasonally adjusted 332,000 in the week ended Feb. 17, the Labor Department said Thursday. The previous week's figure was revised to 359,000 from 357,000. Despite last week's drop, claims still came in above Wall Street expectations. The median estimate of economists surveyed by Dow Jones Newswires was for claims to fall by 35,000 to 322,000. The four-week moving average, which economists gauge for the underlying trend, rose by 1,250 to 328,000.

Housing Existing home prices are as high as they were this time last year Sales have receded only to 2003 levels The only extreme decline is in construction; builders are trying to get rid of the houses they’ve already built before they put up more The overhang of unsold homes could be back to normal by around midyear Houses are affordable even though prices rose more than 50% in the past 5 years (may be due to low interest rates) The decline in the housing market may be a much-needed correction to the inflated housing market

Interest Rates Globalization and financial innovation are 2 key factors in keeping rates low Investors know more about the loans they’re buying, so they will pay more for them Credit default swaps have also improved transparency (if investors bet heavily against an issuer’s securities, its lending costs are driven up) Creates a healthier market and ultimately lower rates

CPI The core CPI, which strips out food and energy prices and is more closely watched by the Fed, jumped 0.3% versus expectations of a 0.2% increase. The rise broke a three-month string of 0.1% monthly gains and pushed the year-on-year rate up 0.1 percentage point to 2.7% Fed officials were broadly upbeat about economic growth prospects, noting that they expected "solid growth" in consumer spending to be maintained and that strong financial conditions and high profits should support "a firming of investment spending."

ISM Non-Manufacturing Index Steady growth in the service sector, which makes up roughly 80% of the U.S. economy, is particularly important now because the manufacturing sector is struggling with high inventories and soft demand for houses and cars The Institute for Supply Management, an Arizona-based group of corporate purchasing managers, said its index of nonmanufacturing business activity in the U.S. rose to 59 in January from 56.7 in December. Readings over 50 indicate expansion, and January's surge marked the 46th consecutive month that the service sector, which includes everything from massage therapists to financial planners, has grown.