At virtually every review meeting we have with our clients the first question that comes up is what is happening to the economy. Most of our clients are concerned about the economy, and they want to know what to expect for 2006.
Unfortunately, we don't have a crystal ball, so we can't predict the future. But perhaps I can shed some light on the economic reports that have been released, and help you understand the facts, and what I think they mean. First, the good news and then a rundown on the warnings for 2006:
- Retail Sales Growing: Retail sales have been growing at a moderate clip for the past few months, and are expected to continue. Even though both auto sales and gasoline station sales have declined, sales of home furnishings, electronics, building materials, and clothing have offset those declines to keep retail sales up. This means that manufacturers will need to continue to build more inventories to sell, and possibly hire more employees.
- Inventories Are Growing: Inventory growth among manufacturers, wholesalers, and retailers has slowed in the past few months as uncertainty regarding growth and energy prices mounted. But now that the economy is expected to expand at a healthy clip in the coming quarters, the danger of high energy prices is mitigated, allowing companies to stop drawing down inventories, use their excess cash to invest in more employees and manufacturing capability, and ultimately generate more revenue and income. As corporate profits rise, the stock market will rise as well.
- Consumer Confidence is Up: The consumer confidence index is a measure of how well people feel about their personal economic situation. With energy quotes down from their highs and with gasoline prices down to their lowest level since mid-June, consumer confidence has rebounded, allowing consumers' incomes to stretch further. This is also a leading indicator, signaling a more optimistic opinion of the future.
- Layoffs Are Decreasing: Layoffs are down, as can be expected from the positive indicators discussed above. With growing sales, and increased corporate earnings growth, many companies will begin to actually hire more workers to keep up with this demand. Also, with a decrease in unemployment claims, you can expect consumer spending to grow.
- Inflation Kept Under Control: Since June of 2004, the biggest concern for the Federal Reserve was inflation because economists believe that too many dollars chasing after goods creates too much upward pressure on prices. To combat inflation, the Fed uses it's only weapon, the control of short-term interest rates. For the past 12 consecutive meetings of the Federal Reserve Board, the Fed has decided to raise interest rates one quarter point at each meeting. These rate increases have worked, for inflation has been controlled effectively throughout this whole period of rate increases.
Excluding energy and food, consumer prices have increased approximately 0.2 percent for each month in the past few months. The yearly rate of core inflation held at 2 percent for a second straight period. When we add energy and food back into the equation, the results should be similar, and barring another spike in energy prices during the winter, the headline level of inflation should ease further.
Now for the warnings:
Interest Rates have risen: In December, Alan Greenspan and his colleagues will have risen interest rates another quarter-percentage point for the 13th consecutive time. That will bring their target for short-term rates, which influence the cost of borrowing economy-wide, to 4.25 percent, the highest in 41/2 years. One and a half years into its rate-raising campaign, some economists think it's time the Fed signal through a subtle shift in language that this era of rate rises may soon end. But with the economy strong, the Fed likely will want to raise rates a couple of more times in 2006 to head off inflationary pressures.
This means that the cost of spending has increased. This has an effect on all types of borrowing. With an increase in mortgage rates, homes are much less affordable, and may curb some of the rampant speculation that has affected the house prices in California and many other "hot" real estate markets in the United States. This can be particularly brutal on "interest-only" loans and other creative mortgage structures that appeared incredibly advantageous when interest rates were so low two years ago, but have since risen (and will continue to rise) with each Fed decision on interest rate increases.
Interest Rate increases also affect all other kinds of debt. Because many loans are tied to the cost of funds, interest rates for car loans, home improvement loans, and credit cards are also increasing. This may have a negative affect on spending.
Finally, increased interest rates affect corporations by increasing the cost of their debt, and can negatively affect profits. This can decrease liquidity and make it more challenging for corporations to continue capital spending. But coupled with all of the "positive" indicators mentioned earlier, this possible negative may not be fully experienced with all the other positive economic expectations.
