The U.S. economy.

• Author: Witte, Willard E.

Overall, 2006 will end up as a pretty good year for the U.S. economy, although not in all dimensions. Growth in total output (GDP) should be close to 3.3 percent (see Figure 1). Payroll employment will have grown by about 1.8 million, and the unemployment rate will have declined by about one-half point (see Figure 2). The output and employment numbers come close to matching our relatively optimistic outlook from a year ago, while the unemployment result is better than we expected.

[FIGURES 1-2 OMITTED]

But there are also some less positive aspects to the current situation. To begin with, the growth in both output and employment decelerated during 2006. At the same time, inflation increased. This was driven in part by a tightening labor market and in part by a significant jump in energy prices. Elevated inflation caused the Federal Reserve to push short-term interest rates upward by more than we anticipated a year ago. (On the other hand, long-term rates have risen only slightly and are actually below our expectation.) Finally, the situation in the housing sector has deteriorated more than we foresaw.

Given this somewhat ambiguous state of affairs, we expect an acceptable performance from the economy in 2007, but not up to the standards of the past few years. There are enough risks in the current situation, however, that a weaker outcome is a clear possibility.

The key to this unfolding drama will be the American consumer. From the end of the recession in 2001 through the end of 2005, consumption spending accounted for 78 percent of the increase in output, with spending on housing construction comprising another 13 percent. Consumption has held up pretty well during the past year, comprising 70 percent of growth in the first three quarters of 2006. Housing, on the other hand has become severely negative, cutting about 0.6 percent from the output growth rate. Part of the decline in residential investment has been made up by business investment and by healthy growth in exports.

We expect a continuation of this basic pattern--consumption at a level that is adequate to maintain forward momentum in spite of continuing declines in the housing sector. Some details:

* We expect real output to grow about 3 percent in 2007. That will be below the 2006 figures and also somewhat below the long-run potential of the economy.

* Employment will expand by about 1.7 million. This may be enough to bring the unemployment rate down slightly. For Indiana, this...