By Neil Irwin
Washington Post Staff Writer
Sunday, January 1, 2006

A year ago, the overwhelming consensus of economic analysts was that the U.S. economy would grow strongly in 2005.

But if you had told those forecasters about some of the challenges the nation would face in the past year -- the destruction of a major city, gasoline prices that for a time hit $3 a gallon, a slowing in the housing market late in the year -- you likely would have persuaded them to predict a year of weaker growth.

You would have persuaded them wrong. The consensus turned out to be exactly right, as the nation's total output looks to have grown by about 3.7 percent over the course of the year, despite the headwinds.

There's a lesson in that as forecasters try to figure out what the economy will do in 2006. One can never be sure what will fill the business pages next year (a big hedge fund collapse? a General Motors bankruptcy?). What one can do is try to understand the underlying trends in the economy, the big, slow-moving forces that shape the nation's collective financial prospects. Think of the U.S. economy as a tanker ship, constantly buffeted by waves and wind -- this oil price spike, that currency devaluation -- but changing direction only gradually and when bigger economic forces are at work.

So what underlying path is the economy on for 2006? Forecasters generally believe it is going to grow at a healthy pace, though slightly slower than in 2005. Economists at Lehman Brothers Holdings Inc., the investment firm, expect sufficiently smooth sailing that they illustrated their 2006 forecast with a photo of a sailboat moving across placid waters. Their outlook reflects the consensus view.

The Bond Market Association surveyed economists at 29 member firms, mostly big investment companies. They expect gross domestic product, which measures the value of all goods and services produced in the United States, to grow 3.4 percent next year -- reasonably strong by historical standards, but down three-tenths of a percentage point from 2005.

That doesn't mean the economic outlook is all sunshine and sailboats. Economists see a slumping housing market to be the biggest risk for the economy in 2006, as interest rates rise and housing supply rises to meet -- and, increasingly, exceed -- demand. Just last week, the National Association of Realtors said that the number of homes on the market rose to its highest level in more than a year. The consensus of the economists surveyed was that the number of existing homes sold will drop 6 percent to 6.7 million, and that the number of houses builders start building and the number of new-home sales will also fall.

"Clearly the slowdown in housing will mean slower growth in the overall economy," said Nigel Gault, an economist at consulting firm Global Insight Inc. "The big question mark is how much damage there will be."

The answer may depend on just how much the steady growth in recent years has depended on housing. It would appear to be a lot. Economists at Wells Fargo & Co. analyzed job growth since 2001 and found that half of the nation's new jobs have been in fields tied to housing -- real estate agents, mortgage brokers, construction workers and the like. And booming housing prices appear to be a major factor in the rapid climb of Americans' spending in recent years, which many economists argue has been enabled by cash-out refinancings, home equity loans and a sense that they need not save because their homes made them worth so much on paper.

With all those factors in play, Moody's Economy.com Inc., an economic consultancy, estimates the booming housing market added 1 percentage point to economic growth in 2005.

"Unfortunately," writes Lehman Brothers economist Ethan Harris in a report, "the housing boom and the spending it fuels is unsustainable."

If the slower housing market has a worse impact on the overall economy than mainstream economists forecast, it could even spell the end of the four-year economic expansion. Mark Zandi, chief economist at Economy.com, figures the probability of a recession in 2006 is 10 percent, given the strong momentum in the economy. But he raises the likelihood to 20 percent for 2007.

Economists are counting on the corporate sector to pick up the slack. After three consecutive profitable years, large companies are sitting on stockpiles of cash, and inventories are low -- business inventories have fallen by an annualized $35 billion in the first three quarters of 2005, according to Commerce Department data, and some economists say that companies are primed to build them back up. That could contribute to growth in 2007.

One indicator of the economy's outlook is already predicting recession. Usually, long-term interest rates are higher than short-term interest rates. Once in a while, that situation reverses itself, indicating investors believe the economy will be slowing. Such a shift, called an "inversion of the yield curve," has foreshadowed each of the last six recessions (but falsely predicted one in 1998).

It happened last week, as the yield on a 10-year Treasury bond rose above that for a two-year bond.

"I do believe the bond market is trying to tell us something," said Scott Anderson, an economist with Wells Fargo & Co. "Whenever the yield curve inverts, one ignores that fact at their peril." Other economists think that the indicator is less useful as an economic predictor now than in the past.

With rumblings of a slowdown, possibly even a significant one, economists generally expect the Federal Reserve to stop raising interest rates soon, after a 19-month span during which it has raised the benchmark federal funds rate 13 times, most recently on Dec. 13, to 4.25 percent. Inflationary pressures, they argue, have been tamed, and raising rates too much higher would threaten the expansion. Many analysts expect the Fed to raise rates two more times, to 4.75 percent, once at Chairman Alan Greenspan's last meeting of the Federal Open Market Committee and once at the first committee meeting led by Ben S. Bernanke, his presumed successor.

"Bernanke will want to raise rates at least once after he takes over on Feb. 1, 2006," writes Diane C. Swonk, chief economist of Mesirow Financial Holdings Inc. "This will help establish his inflation-fighting credibility with financial market participants."

There are other risks -- and some things that could surprise positively -- in the economic outlook.

Energy prices are one of the big uncertainties. According to Bloomberg News, the price of oil averaged $56.70 a barrel in 2005, up 37 percent from 2004. Analysts surveyed by Bloomberg expect that price to average $58 in 2006.

Some forecasters expect the trade deficit, which was a record $68.9 billion in October, to ease in 2006, as Americans import fewer goods and save more amid slower consumer spending. That would improve economic output, particularly if it is accompanied by an increase in exports.

The economists surveyed expect the dollar to weaken against other major currencies, which could both result from and aid that trend; the consensus was that a dollar will buy 111 yen at the end of the year, down from 119 now, and that it will by 0.8 euros, down from 0.85 now.

Then there are the ultimate imponderables -- terrorist attacks, hurricanes, earthquakes, corporate collapses, political events and anything else that could shake the nation's economy. But whether any such unforeseen events have much impact will depend on how strong the underlying economy is, analysts argue.

After the Sept. 11, 2001, terrorist attacks, the nation slid into recession. But that may have reflected more the tenuous state of an economy reeling from the collapse of the stock bubble and technology companies than the damage of the attacks per se. In 2005, Hurricanes Katrina and Rita and the resulting spike in fuel prices caused barely a macroeconomic blip, because the economy was on solid footing at the time. That's why economists are keeping their eyes on the housing market and consumer spending, which have been mainstays of the economy in recent years.

"We're taking a major source of growth and turning it into a drag," said Zandi, the Economy.com analyst. "At that point, the economy will be vulnerable to any other thing that might go wrong."