Brooklyn's Progress
February/March 2007

BY MITCHELL J. HELD, MANAGING DIRECTOR, ECONOMIC AND MARKET ANALYSIS, CITIGROUP

What do Central Bankers dream of?  They dream of a fairy tale world where GDP growth is good and inflation is under control.  And if they really want to push the fantasy, they would love to see inflation decelerate further, too.  Stay asleep Fed because right about now, your fantasy world closely approximates the real world.

Real GDP grew at a 3.4% annualized rate during 2006’s fourth quarter and 3.5% for the year as a whole.  This follows increases of 3.2% in 2005 and 3.9% in 2004.  Housing and autos have been the economy’s rough spots, but swift production cuts in both industries have thus far limited contagion to other areas.  While the housing sector may be in the process of bottoming, that usually takes some time and we would be surprised to see the sector contribute favorably to economic growth before later in the year.

Elsewhere, though, things are humming.  Adjusted for inflation, consumer spending rose 4.4% in the final quarter of last year and should come close to that in the current quarter.  The balance sheet looks strong, real disposable incomes are high and so are consumer attitudes.  Capital spending has disappointed but orders seemed to pickup towards the end of the year.  And the trade balance is shrinking, primarily because of increased demand for U.S. goods and services from our foreign trading partners.

Lower energy prices have helped to soothe economic concerns in recent months, but even beyond energy and food, inflation may be easing as well.  In December, the PCE Price Index core rate slipped to 2.2% on a year-over-year basis (it had been as high as 2.4%) while its quarterly average fell to 1.9%, SAAR, about one-half percentage point off of the peak.  It’s still too soon to flash the “all’s well” sign, as the level of the unemployment rate, at 4.6%, just 0.2 percentage points above its cyclical low, bears watching.

June 2004 through Jun 2005 marked a two-year run, during which the FOMC (Federal Open Market Committee) raised overnight lending rates by ¼-percentage point per meeting for 17 consecutive meetings (from 1% to 5¼%).  Since then, there’s been a break in the action.  Assuming conditions described above hold, it’s possible that the Fed remains on hold for most of the rest of the year, leaving short-term rates fairly steady.  Long-term rates could drift higher.

Bottom line:  The economy seems to be doing just what the doctor ordered.  Since spring, the U.S. economy has slowed but now in is the process of mildly reaccelerating.  It seems set to grow on a glide path of 3%-3½% or so on average over the next few quarters.  This should keep inflation concerns at bay.  And it should keep short-term rates from rising – or falling – for now.

Mitchell J. Held is a managing director in the Economic and Market Analysis Department of Citigroup Global Markets. Mr. Held focuses on delivering the economic message to Smith Barney’s Private Client Group.  He began his career in Citibank’s economic department in 1976, joined Smith Barney in 1981 and served as the firm’s chief economist in the late 1990s.  He now has more than 29 years of experience in the economics and investment field.  Mr. Held earned his BA in economics at George Washington University and his MA in economics at New York University. In addition to Smith Barney, Citigroup, a leading global financial services company, includes under its umbrella Citibank, CitiFinancial, Primerica and Banamex. Additional information may be found at http://www.citigroup.com/