Economic conditions point to a good year: GDP is forecast to grow 4.4% in the first half of '06, 3.2% in the second

MMR, May 8, 2006

NEW YORK -- The mass market retailing industry can expect an accommodating business outlook for the balance of 2006 and throughout 2007, several barometers indicate.

Although oil prices have reached record levels and core inflation--which excludes energy and food costs--made its biggest jump in a year during March, the Federal Reserve Board has expressed caution about further interest rate hikes, and sustained job gains and rising corporate investment through 2007 should cause consumer demand to remain resilient.

An MMR compilation of analyses of key measures of overall economic activity for 2006 and 2007 confirms that there is a significant degree of optimism about the prospects for the economy.

For example, the latest forecast from the award-winning University of Michigan's Research Seminar in Quantitative Economics is that real GDP for 2006 will rise by 3.5%, compared with a 3.5% rise in 2005 and a 4.2% increase in 2004.

"Fiscal policy is likely to be expansionary in 2006 due to higher federal spending for defense, the continuing needs of homeland security, federal aid in response to the hurricanes and the launch of the prescription drug program under Medicare," says University of Michigan forecasts director Saul Hymans.

"Following the temporary soft patch of late last year, real GDP is forecast to register growth rates of 4.4% during the first half of this year and 3.2% in the second half. The acceleration in the first half of 2006 reflects a step-up in defense spending, the rebuilding efforts in the Gulf region, a moderate recovery in the pace of light vehicle sales and stronger export growth."

What will the economy be like in 2007? Hymans maintains that GDP will grow by 2.5% during 2007, as measured from fourth quarter 2006 to fourth quarter 2007. But he sees the second half of next year displaying a less vigorous, though still solid, rate of expansion as home-building activity declines in response to higher mortgage rates and the pace of light vehicle sales stabilizes.

Will the inflation rate be rekindled in 2006 and 2007?

According to Value Line economists, the Federal Reserve's ratcheting up of short-term interest rates is an acknowledgment of the potential for inflation to wreak havoc on the U.S. economy. Those worries seem realistic, they add, given the long-running nature of the economic upturn, the rising pattern of oil prices and the recent tightening in the labor market.

The consumer price index, according to the University of Michigan forecast, will increase by 2.6% in 2006, a rise slightly less than 2004's 3.4% increase. For 2007 the forecast estimates that the increase in the index will edge down because of the slowing economy, and it projects a gain of only 1.9%.

The direction of interest rates will unquestionably be upward during the first half of 2006. How high and how fast rates will climb will depend on the data, particularly after March's sharp inflation increase. Economists expect the Federal Reserve to adhere to its stated policy of a slow and steady increase in federal funds rates.

Will the unemployment rate continue to fall in 2006 and 2007 as it did in 2005? Will the current slow but steady job gains continue to be a key engine to the economic recovery?

More and more economists believe the answer to both of these key questions for mass retailers is a resounding yes. The University of Michigan projects that employment will respond to the strong economic growth, leading to a slide in the unemployment rate from a 5.1% average last year to a 4.7% average for both calendar 2006 and 2007. This translates into job gains of around 2.2 million during both 2006 and 2007, or 183,000 new jobs per month.

Economist Joel Naroff, president of Naroff Economic Advisors, says, "Businesses are apparently seeing strong enough growth in demand for their goods and services to look for more workers, and businesses are being forced to pay for them because wages also are rising strongly. The job market is becoming more and more friendly if a person is a worker or looking to become one."

Two other key indicators for mass retailers are the trends in motor vehicle sales and housing starts, normally among the most cyclical sectors in the economy. Cheap money has fueled a continuing boom in the real estate market and allowed car makers to offer low-interest or no-interest car loans, prompting consumers to keep spending.

The Federal Reserve is not expected to raise rates fast enough or high enough to completely stop growth in these two vital sectors of the economy. Many mass retailers have important product lines tied to the housing sector. Mortgage rates are still relatively low, but have been on the uptrend lately. However, they are not expected to jump sharply. Home-building activity shows the effects of rising mortgage interest rates, with housing starts expected to slip to 1.96 million units this year, down from last year's 33-year high of 2.07 million starts, and falling further to 1.77 million units in 2007.

Auto companies are also expected to have a pretty good 2006 in terms of sales, even though it may involve the heavy use of dealer incentives. Sales of light vehicles are expected to total 16.9 million units in 2006 and 17.1 million in 2007, little different from 2004 and 2005, but behind the record 17.3 million units sold in 2000.