Starting 2007, the national and local economies are sputtering. The recession in the home building industry sliced a full percentage point off the nation’s Gross Domestic Product growth in 2006 and closer to 1.5 percentage points off the Gross Regional Product.

During 2007 two outcomes seem possible: the recession in housing becomes worse, pulling down the rest of the economy; or the housing market stabilizes, giving the other parts of the economy the opportunity to continue to grow. These extreme outcomes, recession or no recession hinging on the performance of a single industry, seem especially relevant to areas like San Diego that have been tagged “bubble” markets, reflecting the rapid home price appreciation since 2000 compared to the national average.

The San Diego Association of Governments sees no housing-induced recession during 2007.

Data from the National Association of Realtors shows the decline in home sales, the increase in the inventory of units for sale and the median sales price per unit all started to level off about July 2006. In addition, the housing slump does not seem to be spreading to other parts of the national economy. For example, the stock market turned up during the second half of 2006, the unemployment rate is low and stable, real wages are rising, interest rates are still low by historical standards, credit spreads are narrow, corporate profits are healthy and the exchange rate for the dollar is slipping to make our exports more attractive.

Although a recession during 2007 is unlikely, the national and local economies are expected to be weaker than 2006. Nationally, the GDP is expected to increase 2.7 percent, down from an estimated 3.3 percent growth during 2006. Locally, the GRP, an estimate of the total goods and services produced in San Diego, is expected to increase 2.4 percent, 0.3 percentage points below the nation and below the near 2.6 percent growth estimated to have occurred in San Diego County during 2006.

Last Year’s Scorecard

The forecast on these pages a year ago called for the nation to exhibit strong growth during the first half of 2006, followed by a weak second half, providing an overall GDP growth rate of 3.4 percent for 2006. Our national forecasts were on target; the nation’s GDP expanded by 4.1 percent during the first half of 2006, slowing to an estimated 2.1 percent during the second half, providing an overall estimated growth rate of 3.3 percent for 2006. However, we thought the local economy would fare better than the nation’s during 2006 and it did not. Locally, GRP increased 2.6 percent during 2006.

Last year we tagged rising inflation as the single most important downside risk for the national and local economies. We expected the core rate of inflation to be at or above the Federal Reserve target level of 2 percent throughout 2006, forcing the Fed to raise the federal funds rate 75 basis points during 2006 to 5 percent, which would derail the already slowing housing market. The Sandag forecasts proved to be on target; the core rate of inflation (excluding energy and food) averaged 2.5 percent during 2006, the Federal Reserve raised the federal funds rate to 5.25 percent and the housing market cooled significantly during 2006.

We expected businesses nationally to continue hiring a sufficient number of new workers during 2006 to keep the nation’s unemployment rate at or below 5 percent. Although job growth was weaker during 2006 than 2005, the nation’s businesses added enough new workers to push the unemployment rate down to 4.6 percent.

In San Diego, we expected 22,000 new industry jobs to be created and the unemployment rate to fall to 3.9 percent. Furthermore, we expected job losses in the weakening construction sector to be more than offset by job gains, led by an expanding visitor industry. Here our local forecasts were on target. The latest data available show that the local economy added 20,000 jobs during 2006, pushing the unemployment rate down to the expected 3.9 percent. As we expected, the construction industry shed about 3,000 jobs from its 2006 peak, while the visitor industry added more than 9,000 jobs during 2006, more than offsetting the weak construction sector.

After outpacing the nation’s growth in 2004 and 2005, San Diego’s economy fell behind last year and is likely to do the same this year, Sandag forecasts. If you feel distressed, check out 1990-91. GDP is gross domestic product and GRP is gross regional product. Both are estimates of the total value of goods and services produced in an economy.

Labor Markets Are A Double-Edged Sword

Nationally and locally, in 2007 we need employment growth to continue to be strong enough to offset the weak construction sector; if not, both economies could tumble into a recession. At the same time, nationally the unemployment rate is below full employment, putting upward pressure for inflation through rising wages. That could force the Federal Reserve to raise interest rates, creating more weakness in the housing market and other interest rate sensitive sectors, pushing both economies into a recession.

The orthodox thinking on inflation today suggests that it picks up when GDP growth exceeds “potential” for long enough to push the unemployment rate below its inflation-neutral rate, referred to as the non-accelerating inflation rate of unemployment or NAIRU.

Economic determinants of potential growth are simply the combination of labor supply and labor productivity, which together imply a potential growth rate for the economy of about 3 percent. With this line of reasoning, inflation continues to accelerate until the unemployment rate rebounds back to NAIRU, considered by many economists to be 5 percent.

The nation’s unemployment rate was 4.6 percent at the end of 2006, below the NAIRU rate. Adding to our concern over inflation is slowing productivity growth and the likelihood the reprieve we have seen from rising commodity cost pressure may be short lived. If the Federal Reserve wants to combat inflation, it must push GDP growth below potential for long enough to create significant spare capacity in the economy.

On the brighter side, rising global trade and competition tend to lower inflation through the threat or reality of cheap imports. Finally, inflation is influenced by expectations; the more faith in the Federal Reserve to curtail inflation, the less the expectations for higher inflation in the future. This faith is likely what has kept long-run interest rates down despite the rise in short-term rates over the past two years.

Overall, Sandag considers the upside risks to inflation to exceed the downside risks. During 2007 we’re leaning away from the consensus view on inflation. We expect the core rate of inflation to stay above the Fed’s 1 to 2 percent comfort zone, making it difficult if not impossible for a lowering of the key federal funds rate.

San Diego’s Job Outlook

San Diego’s economy is expected to perform below the nation’s during 2007 and a slowdown in job growth is one of the main reasons. Expect job growth during the coming year to be significantly below last year with a rise of only 15,000 industry jobs, 5,000 less than were added during 2006. The number of jobs created will be sufficient to keep the local unemployment rate below the state and nation, but up slightly to 4 percent from the 3.9 percent recorded during 2006.

Employment growth in professional services, educational services, leisure and hospitality are expected to be the strongest sectors. The gains are expected to be spread across these sectors, unlike 2006, which saw a majority of the jobs created in leisure and hospitality categories such as hotels, restaurants, amusement parks, convention operations and cruise ship support. In addition, look for continued growth in the region’s defense industry, in part responding to the military’s needs to support operations in Afghanistan and Iraq.

Some industries are expected to lose jobs during 2007. We have mentioned the construction sector, and forecast a 3,000 job decline during the coming year, the largest decline of any sector. Local government will lose a modest number of jobs, led by the city of San Diego as it continues to deal with its financial woes; we expect more long-time employees to retire and the newly acquired ability to outsource to reduce the ranks of municipal employees in the region’s largest city.

Of concern are some of the industries that make up our high-technology sectors, including medical research, biotechnology, medical instruments and defense contracts. Recent announcements suggest we will be losing some of the growth in the medical research area to Florida and that a major defense contractor may be relocating its headquarters out of San Diego. In light of these concerns, we are showing no growth in our high-technology areas during 2007, despite the expected influx of more than $1 billion in venture capital funds in 2007.

Housing’s Multi-Stage Correction

The housing market appears to be searching for a floor from which it hopes to pick itself back up. If so, how far along is the housing correction?

Housing corrections happen in stages. In stage one, demand falls rapidly, but supply is sticky — homeowners are reluctant to cut prices and builders, ever optimistic, are slow to cut production — and inventories build. During the second stage, the drop in demand slows and supply falls to meet demand. This decline in supply comes because of a sharp drop in new home production and sellers deciding now is not a good time to sell after all, taking their houses off the market.

San Diego is one of the bubble housing markets. The median price of a home here probably will decline by about 5 percent this year, falling to $465,000. Housing prices will not sink and a major collapse in residential real estate values is unlikely as long as the economy and job growth remain healthy and any rise in interest rates is modest.

It is worth noting that such a small drop in home prices only takes away a quarter of a year’s worth of the rise in prices during the run up. Only buyers at the very peak of the market will find themselves underwater on their investment. And really, isn’t giving up one quarter’s growth in equity a small price to pay to live in a paradise of low unemployment, plentiful opportunity and weather that is still the nation’s envy?

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