Modest forecast, at best, for 2006*

By Tapan Munroe

As we look ahead to 2006, several questions come to mind about the state of the U.S. economy. Will its amazing resilience seen in the past six months continue next year? Is the boom about to fizzle on the remarkable run of the real estate and construction industries?

Finally, what are the economic risks? The economic impact of the Gulf Coast hurricanes and the subsequent energy price increases caused considerable concerns about the sustainability of economic expansion last fall.

The good news is that the economy is on a comeback trail despite the hurricanes and their aftermath. November payroll growth of 215,000, with big gains in construction and services, exceeded analysts' expectations of 210,000. This was the best job gain in four months. The third quarter gross domestic product was revised upward to 4.3 percent, the strongest showing by the economy since first quarter 2004. The brisk pace of the economy was fueled by higher spending by businesses and consumers despite record energy prices.

Since the end of the 2001 recession, the real estate and construction industry boom has been a key strength of the economy, both for job creation and household wealth building.

According to the Federal Reserve, household net worth increased by 2.6 percent to a record $51 trillion in the third quarter of this year. The increase happened because of the value of household assets such as stocks, bonds and real estate, increased faster than household debts, including mortgages.

In the aftermath of the dot-com bust-induced recession of 2001, real estate holdings have begun to occupy an increasing share of net worth relative to equities.

But real estate markets -- Bay Area, state- and nationwide -- in recent months have shown signs of cooling. Pending home sales are down, as are the rate of home-price increases. Homes also are remaining on the market longer than they used to, another indication of a slowdown. We are now seeing houses stay on the market twice as long as they did a year ago. Speculative buying of homes -- a major feature of the housing boom -- also is slowing down. In major metro markets such as Las Vegas, Phoenix, Miami and San Diego, where speculative buying has been hot, investors are beginning to withdraw from the housing market.

The good news about housing is that there will not be a bursting of the bubble. Instead it will be a soft landing, like a slow leak from a giant soufflé, that will return the sector back to some form of normalcy.

So what's in store for 2006?
The national economy in 2006 is expected to fare quite well with the GDP rising at a rate of about 3.3 percent, compared to 3.6 percent in 2005.

The CPI in 2006 is expected to be around 2.4 percent, down from 3.8 percent in 2005. The assumption here is that energy markets next year will not be riled up again by natural disasters or serious problems in the Middle East.

Payroll employment growth is expected to be 1.3 percent. The unemployment rate is expected to be around 5 percent, slightly lower than the 5.1 percent this year.

I expect that the Federal Reserve will continue to be in an inflation-fighting mode for awhile and push up the benchmark Fed Funds rate a few more rounds into 2006.

California's economic outlook is, at best, modest.

The good news is that we do not expect a recession. Payroll employment in the state is expected to be around 1.1 percent, compared to 1.6 percent this year. Real estate's slowdown likely will slow the state's economy as well.

In the East Bay, the economy should outperform other Bay Area economies.

Of course, forecasting is risky business. What could change my economic forecast?

• Inflation. Higher inflation, triggered by troubles in energy markets and resulting permeation of higher prices in other sectors of the economy, will mean higher interest rates.
• A collapse of housing prices, particularly in major U.S. metropolitan areas. It would cause serious problems for the real estate and construction industries, both of which has kept the economy going the last several years. Such a collapse could result in a recession.
• The unforeseen. Let us not forget that most recessions are caused by external shocks such as serious mistakes in economic policy, major political upheavals and catastrophic natural disasters.