Economy in 2006 -- Short Version

As we roll toward '06, the inflation indicator for the short term is signalling
a continuing though less dramatic moderation than the Oct./Nov. period. This is
critical because with wage growth now up to 3.0% yr/yr, the real wage can recover a little. This sets the direction for consumer spending. I also believe housing activity
was shocked by the turmoil of the hurricanes and the spikes in fuels cost. Much
higher heating bills need to be taken into account. Even so, housing should recover
but progress will be modest. There is clear evidence of lost business sales, production
and employment in the wake of the storms. The hits were smaller than I thought they would
be, but bounceback potential is there for early in the year and release of nearly $70
billion hurricane damage relief will be a plus too. Overall the safest bet is to look for growth to accelerate off a flattish final quarter of 2005 and move nicely ahead into mid-year. There may be a slow quarter then, but I look for the year to finish out very strongly
because companies are going to have to begin to add some bricks/mortar capacity by then.
I am more concerned about 2007. Demand is outstripping capacity growth in the US, and
unless capacity grows markedly, the economy will begin to overheat. Profit growth in '06 should stay near 10%, although oil industry profit contributions could slip some as the year rolls on.

My biggest concern is with the continuing profound inflation in fuels costs. We are in a
seasonally quiet period now. Nat. gas is nearly $5 per mcf off its post Katrina/Rita peak
and oil is down $10. to $60 per bl. These are disappointing declines and leave me concerned
as we move into heating season. There is a decent consensus oil will average $54-55 a bl
next year. Devoutly to be wished for at this point. One also has to carefully monitor basic
grain and food commodities. These remain depressed and appear woefully overdue for some
positive price action.

My short rate cyclical indicators point to continued firming by the Fed ahead. Certain key
ones, such as the ISM manufacturing diffusion index have been far too strong to prompt a
let up. Moreover, with 3.0% inflation readings at several points this year, the Fed has no
business keeping short rates so low if they wish to see people begin to rebuild liquid savings.

As I have discussed in several prior posts, banks have been switching to offering jumbo
no or low reserve deposits to counteract Fed pressure on regular reserves. M-3 growth
has accelerated substantially to over 8% yr/yr. Not only will M-3 fund economic expansion,
it is well more than the real economy needs and will flow either into price or asset inflation. Uncle Al has the bubble machine on again, the old fool.

I plan to talk about the stock market in the next post or two. Many market prognosticators, mindful of the four year cycle low (year two of the presidential cycle) are jumping through hoops to find a basis for a hefty sell-off in 2006. As of now, I do not see it, but I have reserved one for 2007.

In all, if commodities do not run roughshod to the upside, it could be a decent year for
the economy/