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Economic Outlook

We expect real GDP growth to slow to 2.9 percent this year, down from last year's gain of 3.5 percent, led by a slowdown in consumer spending and housing. Growth this year should be dominated by business investment and exports, which will likely expand at least as fast as they did in 2005. We also see the target rate for fed funds ending the year at 4.75 percent, suggesting that there is just one more rate hike in the offing. Both calls are below consensus and appear to contradict recent relatively strong economic data as well as the market's expectations for several more official rate hikes this year.

The economic news since the start of the year has been very good, with many industries performing in line with or better than what we had expected. For instance, the January gain in employment, hours, and production (excluding utilities) reflects a solid rebound in first-quarter economic growth, suggesting that it will be at least as fast as our real GDP growth estimate of 3.75 percent annualized. The January industrial production report also shows evidence of the sector and industry rotation that we anticipate in 2006. For instance, business-equipment output rose a relatively strong 0.9 percent in January, indicating continued strong capital spending. Elsewhere, there was evidence of weakening. Output of construction supplies was once again unchanged in January, following no gain in December. This was the first consecutive weak reading for this industry group since early 2003 and is consistent with what we see in other construction and housing-related indicators. For instance, the Mortgage Bankers' weekly purchase index, which is relatively highly correlated with existing-home sales, has been trending lower over the past year. In mid-February, it hit its lowest level in two years (Display 1, top) New-home sales will also be affected as existing-home sales slow because many new-home buyers are sellers of existing homes. Not surprising, some home builders have reported declines in orders and more order cancellations in recent weeks. In February, the homebuilder's confidence index remained stuck at 57 (Display 1, bottom), unchanged from the readings of the past two months and the lowest level since 2001. Importantly, the subindexes tracking sales expectations and traffic of prospective buyers fell one point. In January, home starts and permits rose to the highest level since 1973-appearing to contradict signs of a weaker housing market. We, on the other hand, believe that the January data were skewed by the record mild weather and will revert to a slowing trend soon. Consumer-goods output, excluding the energy sector, did rebound in January, thanks to solid gains in many consumer durable-goods industries such as automotive products and appliances. January's gains, however, still left output well below its fourth-quarter average.	Display 1: Demand for Housing Is Slowing, and Builders Are Less Optimistic
	Mortgage Bankers Association Index of Loan Applications for Housing Purchases
	National Association of Home Builders Housing Market Index
	Source: Mortgage Bankers Association, National Association of Home Builders and Haver Analytics

The strength of January's retail sales-up 2.3 percent-is the one outlier that challenges our forecast. Even excluding volatile auto-dealer sales, they rose 2.2 percent, far above our expectations-evidence of a buoyancy in consumer spending that we did not anticipate (Display 2). The gains were impressive across most major categories. For instance, clothing-store sales rose 4.2 percent; general merchandise, 2.1 percent; furniture stores, 3.7 percent; motor vehicles, 2.9 percent; building and hardware stores, 3.4 percent; and eating and drinking establishments, 3.6 percent.

Display 2: January Sales Were Lifted by Special Factors Monthly Retail Sales Growth Excluding Autos

Plot points depict the month-to-month percent change in non-auto retail sales for the last five years. Monthly outcomes that appear outside of the band of typical results tend to be followed by a correction within the following two months. Source: Census Bureau, Haver Analytics and AllianceBernstein Fixed Income

Rarely have the gains been so uniform. It was almost as if there were one or two extra selling days in the month, with each establishment benefiting just about equally. Perhaps this is what happens when the weather is warmer than expected: sales per day rise.

It's also possible that shopping patterns are undergoing a fundamental shift. January has historically been a month of low sales volumes and heavy markdowns following the big sales-volume months of November and December. Yet holiday gift-givers and consumers are now aware that many items are cheaper in January. As a result, more people give gift cards for the holidays, affording the recipients greater purchasing power once items go on sale, while others delay some regular purchases. Considering January's unseasonable warmth across the country, it would not have taken much of a shift to generate a major impact on overall retail sales.

While consumer sales trends look very robust today, we expect that February will mark the start of a slowdown in consumer spending-a trend that we expect to persist for the remainder of 2006. So far, February has been more typical in temperature terms. Moreover, February sales are unlikely to benefit from the gift-card phenomenon. We also expect consumers to start to feel the combined pinch of slower liquidity growth, lower home-equity borrowing, higher interest expenses, and higher energy bills.

Barring any meaningful reversal in economic momentum, we think that it is probable that the Federal Reserve will raise rates once more at the meeting of the Federal Open Market Committee (FOMC) at the end of March. But this will likely be its final such move this year.

Ben Bernanke, the newly-appointed Federal Reserve chairman, gave a very balanced speech this week to the Senate Financial Services Committee, saying that he was comfortable with FOMC forecasts of real GDP growth of 3.5 percent in 2006 and 3-3.5 percent in 2007, and with its core-inflation estimates of 2 percent this year and 1.75-2 percent next year. He also agreed with the FOMC's assessment "that some further firming of monetary policy may be needed," adding that "monetary policy actions will be increasingly dependent on incoming data."

Importantly, Bernanke did not call the current pace of economic activity brisk or say that it threatens the balance of risk between growth and inflation-as his predecessor often did when telegraphing a further rate hike. Instead, he said that the most recent evidence on production, orders, employment, and retail sales "suggests that the economic expansion remains on track."

Perhaps this is Bernanke's way of conducting monetary policy: never giving signals or hints, the way Alan Greenspan did. On the other hand, this latter statement suggests to us that he also sees the January sales data as an aberration.

Mr. Bernanke also stated that he did not think that the current yield curve inversion was a harbinger of a sharp slowdown in the economy. According to him, an excess of saving relative to investment opportunities indicates that the yield curve is going to be flatter now than in the past.

We agree that increased global capital flows reduce the usefulness of the yield curve as a predictor of economic growth, and we do not see the curve inversion as a sign of an impending recession. However, our proprietary liquidity measure does suggest economic growth will slow this year. At this time, it is fair to say that only residential housing has confirmed our forecast, but this is significant because housing is such an important cyclical sector. Very often, its twists and turns are harbingers of change elsewhere in the economy.

Importantly, even though we see U.S. growth slowing in the coming year, we also see long yields rising a bit between now and year-end. Our research shows that U.S. interest rates are more closely tied to global interest rates, and with the Bank of Japan and the ECB expected to tighten monetary policy in 2006, we expect some of the rise in global rates to be reflected in the U.S. yield curve as well. With the flat yield curve causing forward interest rates to be at or below current rates, even our modest rate change forecast suggests that portfolio should maintain a short duration position.

January retail sales were very strong, helped by record warm weather and perhaps by a nascent shift in buying patterns. In the past, relatively large gains in retail sales have usually been followed by smaller gains or declines in the next month or two. We suspect that the reversal could be quite sharp because there are a number of fundamental factors weighing on consumer spending as well.

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