The economic recovery is indeed on sounder footing, though not quite as strong as fourth quarter gross domestic product (GDP) numbers would suggest. GDP increased at an annual rate of 5.7% in the fourth quarter, an improvement over 2.2% in the third quarter. But about 60% of the fourth quarter’s performance is due to a big shift in business inventories. Firms are restocking shelves after huge drawdowns during much of 2009. The inventory buildup is a good sign, but its contribution to GDP growth won’t be as big during the rest of this year.

For calendar year 2010, we expect GDP to increase about 3.0%, after shrinking by about 2.4% in 2009. High unemployment and scant wage growth will continue to be a drag, resulting in growth well shy of other economic rebounds. Since the 1940s, the first 12 months of a recovery have seen GDP go up an average of 6.5%. Consumers, while showing signs of more willingness to spend, are still weighed down by debt. And businesses will take a wait-and-see attitude toward investment. An abundance of caution means capital spending is likely to post a very small gain. Meanwhile, exports will tick higher while government spending will be neutral overall—up slightly at the federal level but down at the state and local levels. Some help will also come from an improving housing market, which will make a modest contribution to overall economic growth.

The Federal Reserve has two good reasons to wait until November before raising interest rates. One is to allow the economy, which is recovering but still fragile, to get stronger. The other is to avoid attacks on its decisions by congressmen and senators running for reelection.

Though the fourth quarter registered strong growth, the economy remains wobbly after a very deep recession. The monetary policy gurus don’t want to risk short-circuiting a recovery by hiking rates too soon. They’re especially concerned about unemployment, which stands at 10%. With businesses cutting payrolls, the central bank sees no threat of inflation and therefore feels no urgency to raise the federal funds rate -- the overnight loan rate that banks charge each other -- which remains between 0% and 0.25%. We look for a half point increase to 0.75% by year-end.

Fed officials will continue to insist that they’re on high alert for any sign of inflation, in an effort to reassure jittery bond traders. The Fed doesn’t want the markets to raise expectations of future inflation and send long-term interest rates upward. So look for yields on 10-year Treasuries to inch higher, reaching 4% early this year and heading toward 4.25% by year-end as the economic recovery takes hold and anxiety builds about budget deficits and the rising national debt.

Assuming energy prices behave -- which we expect -- inflation should remain mild this year. Look for the Consumer Price Index (CPI) to increase about 2% from December 2009 to December 2010. With unemployment rising toward 10.5% this spring and staying elevated through the year, there will be scant pressure to raise wages and prices. Consumer price inflation from December 2008 to December 2009 amounted to 2.7%. Were it not for oil prices creeping higher after the steep plunge they took in the last quarter of 2008, the CPI would have been lower.

The core inflation rate offers evidence of the mildness. Because it doesn’t include food and energy prices, the core rate offers a more accurate reflection of underlying price trends. Since May, the core rate has been increasing by just one-tenth to two-tenths of a percentage point each month, and core inflation was only 1.8% over the 12 months from December 2008 to December 2009. That’s what’s prompting Federal Reserve officials to say that inflation will remain subdued for some time. The core rate will probably be about 1.5% this year. It’s heavily influenced by rents, and with a weak economic recovery in store, landlords won’t have a lot of leeway to raise the cost of shelter much.

Could inflation still heat up in the months ahead? That’s probably not in the cards. There’s too much slack in the labor market, and the global economy is just starting to mend. Surging prices will be a concern in 2011. How much of a concern will depend on the Federal Reserve’s ability to slowly but steadily reduce all the stimulus it’s been provided to get the economy growing.

The January employment numbers -- along with revisions in the data from the two previous months -- show that job cutting has reached a bottom. But the net loss of 20,000 last month indicates that employers aren’t yet ready to do much hiring. Strong productivity gains in 2009 eased the need to add to payrolls, but the elevated pace of producing more without hiring can’t continue for long. Companies will add hours and overtime, as they did last month, and step up hiring over the next few months.

There are signs of improvement already: Manufacturers added 11,000 workers in January, the first month they’ve hired any since January 2007. Moreover, 52,000 jobs for temp workers were created, the fourth straight month of solid gains. An increase in temporary jobs typically foreshadows increased hiring of permanent workers.

Still, the lingering high unemployment rate and relatively slow pace of hiring in 2010 will continue to hamper economic growth. The unemployment rate -- now 9.7% -- will peak around 10% or so in the spring. And business managers’ caution -- plus accommodating the workforce increase of about 150,000 new laborers each month -- means that by the end of the year, the rate could still be close to 10%. So far during this recession, about 8.4 million jobs have disappeared. In 2010, we’ll see a net gain of about 1 million. Firms will remain cautious until there is more evidence of a broad economic rebound. In some sectors, many high-paying jobs will never return.

The trade deficit will expand for the first time since 2006 -- to more than $480 billion in 2010, equivalent to 3.3% of gross domestic product. That follows its sharpest annual contraction in 18 years and its lowest level relative to the U.S. economy since 1998. Preliminary estimates put the U.S. trade deficit for 2009 at roughly $376 billion, or 2.7% of GDP.

With the U.S. recovery picking up speed, the demand for capital goods, oil, metals and other industrial inputs will increase. Imports will climb 12%, after plunging 25% last year. Faster economic growth in Canada, Mexico and China will offset near-flat demand from the euro zone, Japan and the United Kingdom to push exports back into positive territory. Expect them to register an 8% increase in 2010, after falling by 17% in 2009.

Crude oil prices will creep slightly higher through spring to $80-$85 a barrel, from about $75 a barrel, and should hold around the $80 mark in the summer driving months. The upswing in prices is not due to any major oil supply disruptions or veiled threats by Iranian or Venezuelan leaders to halt exports. In fact, oil supplies are plentiful, while demand for motor fuels remains weak.

Prices are being buoyed by investors betting that a strong and quick recovery will boost demand for fuels to levels last seen in 2007, when the economy was roaring. We think that’s a bad bet to make in the face of an anemic recovery in 2010 that should see U.S. gross domestic product growing around 3%. Still, there’s little chance oil prices will spike toward $100 a barrel, barring an early-season hurricane that takes out Gulf of Mexico oil rigs. Traders these days are more easily spooked by economic reports that hint at a pause in the recovery.

We expect oil prices to average around $75 per barrel in 2010, up from $62 per barrel last year. In fact, oil prices in 2010 won’t be much different than during the second half of 2009, when they averaged $72 a barrel. The Organization of the Petroleum Exporting Countries won’t act to prop up oil prices, despite demands by cash-strapped Venezuela and Iran for the cartel to cut oil exports. Saudi Arabia fears that a quota reduction would hike oil prices to $90 per barrel or higher, choking off the fragile economic recovery, which would dampen fuel demand and cause oil prices to fall. The Saudis, in particular, are concerned that oil at $100 a barrel and gas pump prices well above $3 a gallon will accelerate consumers’ purchase of hybrid vehicles as well as the development of alternative fuels, reducing oil demand in the long term.

Recovery in housing markets will continue to be mild and uneven. Sales of both new and existing homes fell sharply in December, following a few months of improvement in both categories. Some severe winter weather hurt, but so did the last-minute renewal last fall of tax credits for new buyers. The credit now will expire at the end of April (contracts must be closed by the end of June), and that should give a boost to sales in early spring.

If the Federal Reserve follows through with its plan to pull back on policies that are holding 30-year fixed rate mortgages around 5%, the recovery will be tested. Officials just restated their plan to end that support program by March 31. The rates that would likely result -- a fixed rate for a 30-year mortgage at about 5.5%, rising to 6% or so by year-end -- are still low by historical standards. But the increase will discourage potential buyers.

It will be 2011 before housing returns to somewhat normal activity -- starts of about 1 million and sustained annual sales above 6 million. Home sales hit bottom during 2009, totaling only 5.5 million for the year. Sales of new homes, about 15% of the total, hit a record low last year of 374,000. Foreclosure sales will rise to about 2 million this year, dampening home prices. Overall, the national average price will decline about 5% over the first half of 2010, with wide local differences.

Look for the positive momentum from holiday retail sales to continue into 2010. Despite December’s month-over-month decline of 0.3% in core retail sales, the November-December holiday season gain of 1.5% over 2008’s number is encouraging. Many shoppers held out until the end of the season to buy the bulk of their gifts. Overall, though, consumers still wound up spending more on apparel and in online stores than they did in 2008.

But the still lofty unemployment rate will temper consumers’ spending at least through the first half of next year. Sales for 2010 will increase just under 3% from 2009’s sluggish total. For the most part, consumers will continue to focus on necessities, benefiting drugstores, grocery stores, discounters and dollar stores. However, the ease of hunting for deals online will continue to make e-commerce a bright spot, and apparel and other discretionary retailers are starting to see positive results -- at least positive enough for them to keep their fingers crossed for better days to come.

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