Moderate growth leads to stable jobless rate
We have seen a steady decline in the civilian unemployment rate over the past two years. At roughly 5 percent, some economists will make the case that we are at "full employment", which means that any additional decline in the unemployment rate could lead to accelerating wage pressures. In fact, today's jobless rate may be at relatively low levels, but it is not accompanied by a corresponding increase in the employment-to-population ratio. This suggests that some people have dropped out of the labor force and are no longer looking for work because they believe they can't find it. Labor market conditions could improve even with a stable unemployment rate, but with more workers entering the labor force and finding jobs. Incidentally, the Fed will be closely monitoring the jobless rate in coming months because their December 13 post-FOMC meeting statement voiced their concern about resource utilization.

Consumers a steady source of activity
Personal consumption expenditures account for two-thirds of GDP. Without the consumer, where would this economy be? Predictions for consumer spending range from gains of 1.1 to 3.3 percent over the next five quarters, a solid pace but not stellar by historical standards. The 1.1 percent growth rate predicted for the fourth quarter of 2005 reflects a "payback" period stemming from surging motor vehicle sales in the third quarter and plunging (motor vehicle) sales in the fourth.

While gasoline prices are not currently rising - and may be expected to dip further by some economists - they still play a major role in the outlook for consumer spending. In addition to higher gasoline prices, relative to a year ago, consumers are also facing higher heating bills this winter. But with a steady labor market, wage gains should be solid, and this will certainly promote steady consumer spending on the whole. Most economists, however, have pointed out that refinancing activity is likely to decline from the pace of the past few years, and consumers will no longer be able to use their home equity as a cash machine. This could limit consumer spending in 2006.

A rising interest rate environment is not good news for the housing market. The decline in housing starts that is predicted by economists over the next five quarters would bring the level of starts back to 2003 levels. While it is good that levels will remain relatively healthy, the change in housing starts is what matters to growth prospects - and the change is decidedly negative. Declines in housing starts will also lead to a reduction in retail sales for furniture, appliances and other household goods.

Inflation moderation, but still higher interest rates
Economists expect that the worst of the inflation news, stemming from surging energy prices, is behind us. We have already seen sharp spurts in 2004 and 2005; with possibly the last bad news on energy prices in the fourth quarter of this year. Since it did not appear to be the case that higher energy prices were seeping into the core components, economists expect that inflationary pressures will moderate further in 2006. These inflation rates could still provoke the Fed into tightening monetary policy in 2006. After the Fed's post-meeting statement on December 13, many market players concluded that the Fed may have only one more rate hike in its bag - but this week, economists expect that the Fed will raise rates two or more times - with the fed funds rate target potentially reaching 5 percent in the first half of the upcoming year.

Yields on the 3-month bill tend to run on par with the federal funds rate. Since the Philadelphia Fed Survey does not include forecasts for the fed funds rate target, one can use the forecast of the 3-month bill to get a sense of economists' prediction of future Fed policy. Indeed, these forecasts show steadily rising rates through the mid 2006 and then steady rates through the second half of the year.

Typically, rising short rates also lead to rising long rates when the Treasury yield curve is normally upwardly sloped. If the Treasury market is predicting a recession, then the yield curve will invert. We have not yet seen an inverted yield curve, but the spread between long rates and short rates has narrowed significantly in 2005.

Economists are not predicting a recession and they are looking for a continued upward trend in 10-year Treasury note yields. Since these are used to determine mortgage rates, we should also see higher mortgage rates over the next five quarters. Keep in mind that mortgage rates are still relatively low by historical standards, and not all potential homeowners will be hampered by the rising rate environment. This could curtail housing price appreciation since buyers will not be able to afford the same size mortgage loan with higher rates. Alas, in a rising rate environment, consumers who are really intent on purchasing a home can turn to adjustable rate loans that offer lower rates. However, this could backfire if the homeowners' income doesn't grow in tandem with the monthly mortgage payment as interest rates rise.

BOTTOM LINE
Despite slightly higher interest rate forecasts, economists are predicting moderate GDP growth, a steady unemployment rate and a slower rate of inflation. This could bode well for consumer spending since income may be enhanced. However, higher interest rates will certainly hamper housing activity, and high gasoline and fuel oil prices, at least in the near-term, will curtail retail sales.