Dr. Martin Regalia: Econ 101

With the release of the fourth quarter data, it is becoming clear to most economists that the economy has weathered the most recent storm and appears to be gathering momentum. Real GDP growth accelerated to a 3.5% annual pace in the fourth quarter, the economy created more than 500,000 new jobs, and core rates of inflation moved closer to the Fed's comfort range. While the naysayers in the media who forecast that oil and housing would lead to an economic downturn were once again proven wrong, there are still some risks to the forecast. The difference is that the risks now may be coming more from the policy side rather than from the economy. It may be interesting to take a moment to reevaluate the threats to this expansion.

Let's start with energy prices. Consumers' wallets got hit when gasoline prices reached an all-time high of more than $3 per gallon in September 2005 following Hurricane Katrina. That increase was short lived, as prices dropped 30% by December 2005. However, prices at the pump jumped back up in July 2006, again breaking the $3 mark. Since then, gasoline prices have retreated noticeably, dropping 25% to about $2.25 by late January. While current prices remain high by historical standards, there are numerous signs that they may stay in the current range or even drop a bit. 

The recent decline in oil prices is reflecting an increase in production and a flattening in world oil demand which, according to the International Energy Agency, rose only by 0.9% in 2006. The lack of demand growth coupled with rising refinery output has propelled crude oil stocks worldwide, with U.S. inventories steadily increasing from around 270 million barrels in early 2004 to more than 320 million barrels in December 2006, a high level by historical standards. 

Likewise, U.S. stocks of distillate products, which include diesel and heating oil fuels, have increased significantly since spring 2005. U.S. gasoline production and stocks also rose notably throughout 2006. And downward pressure was recently added to prices when consumption of petroleum products in the United States took a dive in December as the demand for distillates and gasoline fell. 

Despite some brief episodes of cold weather, this winter has generally seen mild temperatures. As such, demand for heating oil has been low. And unless the cold weather pattern reasserts itself, heating oil demand should remain subdued, allowing refiners to concentrate on gasoline and diesel fuel production and build somewhat of a cushion before the high driving season arrives.

The concern over the housing market has shown a similar shift. Whereas a few months ago many economists worried that a steep decline in housing values would depress consumption and lead to a broad-based recession, it now appears that housing has bottomed out. While the softness may stick around through the first half of this year, the Armageddon scenario looks more remote.

Housing starts rose in November and December, increasing a total of 11.1% from October. Sales of new homes, which have been on the whole positive since last July, rose 4.8% at an annual rate in December. While sales of existing homes have bounced around a little more than new homes, they have generally been flat since the end of last summer.

Home prices, although still weak, rose a bit in December, as the market continued to struggle to eliminate excess inventory of unsold homes. Housing inventories, which appear to have peaked in October 2006 at 7.2 months' supply, dropped to 6.5 months in December. Moreover, with interest rates holding firm all along the yield curve, the drop in home prices has improved housing affordability. The National Association of Realtors' housing affordability index, which bottomed out last July at 99.6, rose to 109.2 in December. (Index levels above 100 indicate that a household earning the median income can afford a mortgage on a median-priced home.)

Thus, with the housing market at a bottom and the stock market showing gains, the risk of negative wealth effects undermining consumption has fallen considerably in the New Year.

A third risk troubling economists at the end of last year was the elevated rate of inflation, especially core inflation. With both economic and productivity growth slowing in the third quarter, many economists worried that core inflation would remain stubbornly high, or even accelerate, triggering another round of interest rate increases by the Fed. This fear has also proven to be largely unfounded as both topline and core rates of inflation eased throughout the fourth quarter of last year. The statement released after the Fed's January meeting suggests that it will refrain from further rate increases for the foreseeable future.

We wouldn't be true practitioners of the dismal science, however, if we didn't have something to worry about. So while the economic risks are shrinking, the political risks are clearly escalating.

The recent minimum wage bill constructed in the Senate is a perfect example. Not only would the bill raise the minimum wage, but it would include a host of permanent tax increases. Raising the minimum wage would do little, if anything, to address poverty in America and would likely reduce employment among those least able to find other work. It would remove the only chance some would have to start up the economic ladder.

But a minimum wage increase is nowhere near the worst piece of this package. This bill would include billions of dollars of permanent tax increases designed to influence the way private markets compensate executives. In addition, the legislation would remove the ability of corporations to structure themselves to meet overseas competition and deny businesses the deduction for settlements, thus fostering litigation and needlessly increasing the burden on the judicial system.

While the bill would include some worthwhile tax cuts that would shorten the depreciation schedules for certain restaurant and retail construction, extend expensing of certain investments for small business, and extend the Work Opportunity Tax Credit, these temporary benefits clearly do not offset the permanent costs.

Another example of policy risk will come in the form of the ongoing budget debate. The administration submitted a budget that, among other things, underpins economic growth by making the tax cuts permanent. It also seeks to regain fiscal balance by cutting unnecessary government spending and reducing pork-generating earmarks and even begins the process of addressing long-run entitlement issues. The response from congressional Democrats was to vilify the proposal. Is it any wonder that I see political risks escalating?