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Economy remains fragile as 2007 begins

It's clear the U.S. economy is slowing down, and most forecasters polled by see things picking up a bit in 2007. But though they say the odds are against it, some forecasters warn that the risk of a recession is real. By's John W.Schoen.
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As the new year approaches, there seems to be little doubt that the U.S. economy is slowing down — thanks in large part to a long string of interest rate increases by the Federal Reserve that ended over the summer.

There’s less certainty about what comes next — though most forecasters polled by are predicting an end to the slowdown in 2007 followed by a gradual pick-up in growth. And, though they say the odds are against it, some forecasters warn there is a real risk that the economy will slide into recession.

“The economy enters 2007 in a weakened state, and a number of shocks could trigger a recession or near-recession economy,” Ethan Harris, chief U.S. economist for Lehman Bros., wrote in a note to clients this month. Harris pegs the odds of that happening at “20 percent or higher.”

That prospect certainly does not seem to be worrying the stock market, which set another in a series of milestones Wednesday with a day of strong gains. The Dow Jones industrial average rose more than 100 points to close over 12,500 for the first time.

And even though the housing industry is in a deep slump, there are signs that the market may have hit bottom.  Sales of new homes rose for the third time in four months in November, the government reported Wednesday.

With unemployment at 4.5 percent in November, the economy continues to add jobs at a fairly healthy clip. And even though the housing and auto sectors are slumping, service industries have been picking up the slack. Last month, big job losses in construction and manufacturing were offset with bigger gains in retail and services. As the economy continues to slow,’s panel of economists expects the jobless rate to inch up to 4.8 percent for all of 2007.

Economists in our panel see growth in the gross domestic product slowing to 1.9 percent in the current fourth quarter, down from forecasts earlier in the year.  Though they see growth picking up a bit next year, the rebound will be limited; on average, the forecast calls for growth of just 2.3 percent for the full year. By 2008, they expect growth to pick up to 3 percent for the full year.

Given that shorter-term weakness, many forecasters expect the Fed to begin cutting rates sometime next year.'s panel pegs the benchmark federal funds rate at 4.8 percent a year from now, down from the current 5.25 percent. In fact, the bond market seems to agree that a cut is coming and has factored in lower short-term rates in the current pricing of short, medium and long-term Treasury securities.

Inflation, though a bit above the Fed’s “comfort zone” of 2 percent, is still relatively tame by historical standards. But the average forecast from the 10 economists surveyed by sees so-called "core" inflation running at 2.4 percent for all of 2007.

So a lot will depend on whether inflation continues to ease as the economy slows. If it doesn’t, and the Fed maintains its stated “bias” of fighting inflation with high interest rates over giving the economy cutting rates to give the economy a boost, the bond market in 2007 may end up on the wrong side of its bet.

Next year’s economic forecasts come with plenty of other asterisks and “what-ifs.” One of the most common cautions is the possible impact of another round of high energy prices. Though oil prices seem to have stabilized below $65 a barrel, the global economy continues to demand bigger supplies of fuel at a time with the oil industry is still vulnerable to production outages in a number of hot spots around the world. A serious crimp in the global pipeline could send prices spiking, creating a serious inflation problem that would send economists scrambling to re-write their forecast spreadsheets.

Soft-landing forecasts are also counting on the American consumer to keep doing their part to keep the economy growing. Consumer spending now accounts for 70 cents of every dollar of  GDP, and much of the spending has been financed in recent years with debt. As home prices rose, a sizable chunk of that spending was financed by cashing in that rising home equity with refinanced mortgages or home equity loans. Now, with home prices stagnant, debt-financed spending could get squeezed. If consumers pull back too far, the hoped for pick-up in growth next year could be delayed.