Looking back at the economy’s performance during 2005 one has to be impressed with its resilience. During the year, the economy shrugged off a number of unexpected shocks:

• Rising prices for energy products sent the price per barrel of oil above $70 and had gasoline peaking at about $3 per gallon.
  
  
• Rising interest rates were a constant as the Federal Reserve pushed the Federal Funds rate up 200 basis points to 4.25 percent while long-term rates rose 50 basis points.
  
  
• Natural disasters in the form of back-to-back hurricanes Katrina and Rita devastated parts of the Gulf region and sent disruptive ripples through the labor and energy markets.
  
  
• Unprecedented increases in real housing prices that have resulted in a rise in home equity but at the same time made housing less affordable.
  
  
• Increases in the rate of inflation, especially the closely watched core rate that is now slightly above the Federal Reserve’s target rate of 2 percent.
  
  
• Rising international trade and federal budget deficits.
  
  
• Declining consumer confidence.

San Diego will benefit from the natural disasters that have occurred in other parts of the country and world. (photo/lambertphoto.com)

Despite these significant shocks, the rate of growth in the nation’s Gross Domestic Product, representing the value of all goods and services produced in the nation, accelerated from 3.5 percent in the first half of 2005 to 4.2 percent during the second half of the past year. The reasons for the economy’s resilience can be explained in part by the economic stimulus provided by three of the shocks listed above.

First, hurricane economics. The immediate disruptions caused by the hurricanes to energy prices and consumer confidence dissipated quickly and were replaced, in part with a demand side stimulus in the form of insurance payments and anticipation of massive federal fiscal assistance. Also, an increase in one price (energy) does not imply an increase in all prices (inflation). Not that there wasn’t an economic impact, but the influence of the impact was kept minimal by these counteractions.

Second, rising real home prices. The rise in home prices is taking place while inflation and interest rates remain low, an unusual event. This has led to a substantial growth in home equity and as consumers we have been spending a portion of this equity, stimulating the economy.

Third, rising interest rates. Short-term interest rates have been pushed up, but long-term rates have not risen as expected, compressing the historical difference between the two rates. The purpose of raising short-term rates is so long-term rates will rise and reduce consumption, which has not happened. Generally, long-term rates rise because markets are anticipating a rise in inflation and higher interest rates are necessary to protect investors’ purchasing power. The investors’ anticipation of inflation has been influenced by the credibility and reputation of the Federal Reserve under the leadership of Chairman Alan Greenspan. The Fed’s credibility as an inflation fighter is keeping long-term interest rates low, prolonging the stimulus effect associated with low interest rates and thwarting the desire of the Fed to slow the economy down to keep inflation in check.

During the first half of the coming year we’ll see an extension of the solid, yet unsustainable, consumer spending that has been the primary force behind the above trend GDP performance over the last couple of years. Fueling consumer spending during the first half of the year is rising after tax incomes (energy prices are falling) and a continuation of extracting money from rising home values.

But for the consumer, the second half of the year will usher in challenges. The boost in consumer spending from home price appreciation and equity extraction has peaked and will decline, providing less of a stimulus for spending. We expect the core rate of inflation to be at or above the Federal Reserve target level of 2 percent. This likely will push the Fed into more federal funds rate increases, topping out at 5 percent, a rise of 75 basis points from the level at the end of 2005.

The economy is exhibiting important areas of strength. The business side is in good shape. Profits have risen over the last two years, repairing balance sheets and providing for increases in investment and job growth. We expect more of the same during 2006 with near 10 percent growth in capital investment and an average of 185,000 new jobs each month. Job growth will be sufficient to keep the nation’s unemployment rate at or below 5 percent, considered by many economists to be full employment. Accommodative government spending is expected, led by funds spent to rebuild the Gulf Coast.

The nation’s Gross Domestic Product has sustained an “above trend” growth rate of 4 percent for more than two and a half years. Plenty of the momentum built up during the second half of 2005 remains and will allow the U.S. economy to sail through the first half of this year. But, expect GDP growth in the second half of the year to slacken to 2.7 percent providing an overall GDP growth rate of 3.4 percent for 2006.

Last Year’s Scorecard

Our forecast a year ago called for the national and local economy to exhibit extreme resiliency in the face of multiple challenges. First, we expected GDP growth at the national level to slow from a robust 4.4 percent in 2004 to 3.6 percent. The growth rate in GDP did slow during 2005 to 3.7 percent, slightly above our forecast.

Second, we expected enough new jobs to be added to keep the national economy growing briskly and lower the unemployment rate to 5 percent. Job growth during 2005 exceeded the previous year’s level and pushed the unemployment rate down from 5.4 percent to 5 percent (fourth quarter 2004 to fourth quarter 2005). We expected similar trends in the local economy, projecting an increase in industry job growth of 25,000 and a decline in the unemployment rate to 3.5 percent. The latest data available show that the local economy has added 18,300 industry jobs (November 2004 to November 2005) and the unemployment rate is 4.2 percent (due to revisions made by the U.S. Department of Labor in January 2005 the previous year’s unadjusted data is not comparable, making it difficult to report on the accuracy of our 2005 employment and unemployment projections).

In addition, locally, we expected weaker construction employment in the second half of the year (the number of construction jobs declined by 100 between July and November 2005); and robust job growth in the hospitality industry (the number of hospitality jobs increased by 6,000 between November 2004 and 2005, rising nearly twice as fast as total employment and outpacing all other major industries).

Third, we expected a slowdown in the rate of increase in home prices and no price implosion in the residential real estate market. The median price of all houses/condos jumped 21 percent during 2004 and looks like it may end 2005 up about 5 percent, in line with our projections.

Fourth, we expected the Federal Reserve to raise its lending rate to 3.25 percent and for mortgage interest rates to rise to 6.5 percent. The Fed raised the Federal Funds rate to 4.25 percent and mortgage rates at the end of 2005 were near 6 percent. We did not foresee the significant compression between short- and long-term interest rates.

We got all of the trends correct, but were off on specific amounts, some closer than others.

Jobs Brighten San Diego Outlook

San Diego’s economy will fare better than the nation’s during 2006, and job growth will play a key role. Expect job growth during the coming year to be slightly higher than last year with a rise of 22,000 industry jobs, 4,000 more jobs than were added during 2005. Job growth will be sufficient to push the unemployment rate lower, ending 2006 at 3.9 percent, down from 4.2 percent recorded in November 2005.

Employment growth in the hospitality and leisure industry is expected to continue the pace set during 2005, adding 6,000 new jobs during the coming year. Job gains will likely be across many categories, including hotels-motels, restaurants, amusement parks, and travel related services. Visitor and convention destinations like San Diego will likely benefit from the natural disasters that have occurred in other parts of the country and world. Additional job growth will come from openings in education and health services, reflecting the expansions taking place at our post-secondary educational institutions and growth in facilities requiring nurses and other medical care and service providers.

The region’s defense industry is adding new jobs, in part responding to the military’s needs to support operations in Afghanistan and Iraq. Additional jobs are being added to support the research and development operations of local companies that receive defense-related contracts. R&D employment in the telecommunications and biotechnology will likely increase during 2006 as a result of the growing amount of venture capital funds businesses in these industrial clusters are attracting. San Diego attracted more than $1 billion in VC funds during 2004, the latest data available. The longer the low interest rate and inflation climate lasts the greater the VC funds available for regions like San Diego.

Not all industries will contribute to San Diego’s expected job gains. State and local governments will likely continue to be weak, new employment opportunities kept in check by poor fiscal conditions. The red-hot construction industry appears to have peaked; a slight decline in jobs was recorded during the second half of 2005. We expect the industry to remain flat during 2006. With the expected decline in consumer expenditures and the continuation of more consumer goods being purchased online, we expect little to no growth in retail trade.

Housing’s Effect On The Economy

The slowdown in the rate of increase in residential real estate will continue through 2006 with prices rising about 5 percent, staying slightly ahead of inflation. The projection is for 12,000 new residential permits to be authorized during the year, slower than 2005, because of an expected decline in apartment conversions to condominiums. (photo/alandeckerphoto.com)

Locally, the slowdown in the rate of increase in residential real estate began in about the middle of 2005 and will continue through 2006, with prices rising about 5 percent during the coming year, staying slightly ahead of inflation. We project 12,000 new residential permits will be authorized during the year, slower than 2005, because of an expected decline in apartment conversions to condos. We don’t expect a major collapse in residential real estate values in San Diego as long as the economy and job growth remain healthy and the rise in interest rates remains modest. The housing “correction” should cool off the consumer, but because of lags involved, the first signs of consumer weakness probably will not occur until the third quarter.

Housing has played a major role in extending consumer spending over the past couple of years. The source of the consumer spending is the build up in home equity. Generally there are two ways to measure this effect: one is equity extraction which stems from refinancing or moving from one house to another. Nationally, surveys show that households spend about 30 percent of their extracted equity on consumer products. A second measure is the wealth effect, where households are willing to spend about 6 cents of every equity dollar. Applying the wealth effect to our local housing markets shows that San Diego households have increased consumer expenditures by $9.6 billion since 2000 with the peak year occurring in 2004 at nearly $2.4 billion. Not all of the “wealth” has been spent, however, the slowdown in the rate of increase in home prices has slowed equity buildup and this is expected to dampen consumer expenditures beginning in the third quarter of this year.

Inflation Is The Looming Threat

In recent months the inflation outlook has become increasingly foggy. Keeping in mind that expectations drive inflation, household inflation expectations have surged in the aftermath of the Gulf Coast hurricanes. Inflation expectations have jumped from about 3 percent to 4.6 percent with much of the increase due to the high price of gasoline and warnings of an expensive heating season. Some evidence is emerging that commodity price increases are being pushed through to the consumer. Measures of the core rate of inflation, closely followed by the Federal Reserve and excluding the volatile components of energy and food, show that it is near the 2 percent limit identified by incoming Fed Chairman Ben Bernanke. If challenged by a rising core rate of inflation most Wall Street economists expect Bernanke to establish his anti-inflation credentials with further hikes to the federal funds rate.

The Fed’s top priority is to maintain price stability, even if it pushes the economy into a recession. This makes rising inflation perhaps the single most important downside risk for the national and local economy during 2006. Let’s hope the Fed does a better job of managing the nation’s real estate price bubble than it did with the “irrationally exuberant” stock market bubble in 2001.

Marney Cox is the chief economist for the San Diego Association of Governments.