Slowdown Coming in the Economy

Rising gas prices, higher interest rates, and a softer housing market will begin to sap consumer confidence in the months ahead.

By Jerome Idaszak, Associate Editor, The Kiplinger Letter

April 12, 2006

High summer gasoline prices will soon slow the economy. The snappy pace of growth in the first quarter was the high for the year. We expect the economic pace to gradually decelerate in coming months, slipping to about 3.5% this quarter, 3% in the next and a hair less than that as the year winds to a close. For the full year, figure on gross domestic product (GDP) rising a little more than 3%—still healthy, but down a few ticks from the 2005 pace.

The main reason: Consumers won't spend quite as freely. Pricey pump prices—likely to average $3 a gallon across the nation this spring—along with the softer housing market and higher interest rates, are nibbling away at consumer confidence. That'll lop a half percentage point off spending growth. Considering that consumer spending accounts for roughly 70% of the U.S. economy, that's a stiff hit.

Fortunately, employers are likely to continue hiring at a fairly brisk pace, preventing an even bigger decline in consumer spending. The robust gain of 436,000 new jobs in February and March combined was probably also the high point for the year. But we expect businesses to add to payrolls an average of about 160,000 names a month, yielding a solid 2 million net new jobs by year end. With potential productivity gains largely exhausted and order books full for the remainder of this year, firms simply must add staff to meet demand.

A solid 8% increase in business spending this year will also help keep the economy buoyant. Makers of industrial machinery, mining equipment and supplies for energy exploration and distribution particularly should benefit as companies spend about 10% more this year than last on new equipment. But look for sales of construction equipment to lag as home building slows down. Sales growth in information technology should also slow as many firms complete their upgrades. Overall, U.S. businesses won't see profits grow quite as much this year as last—about a 9% increase after four years of double-digit annual gains.

We expect the Federal Reserve to end interest rate hikes after its May meeting, when the benchmark federal funds rate will be pushed to 5%. By late June, when Fed officials meet again, signs of moderating economic growth will be clear enough to justify taking a pause. As the cumulative effect of 16 rate increases finally nudges the economy into a lower gear, inflation should simmer down, ending the year at a relatively tame 2.8%.

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