By Nell Henderson
Washington Post Staff Writer
Thursday, February 1, 2007; A01
The U.S. economy turned in a surprisingly strong performance last year, new data show, growing 3.4 percent despite higher interest rates, high oil prices and the sharpest housing downturn in 15 years.
The report from the Commerce Department, showing that economic growth picked up in 2006 from the 3.2 percent growth of 2005, dispelled any lingering doubts about the momentum of the economy going into this year. Many economists predict growth will slow this year, but gone are the recession worries of last summer.
"Nothing, other than an external shock, will derail the economy this year," said Eugenio J. Alem?n, senior economist at Wells Fargo. "The economy's in good shape."
Unemployment and inflation fell last year while wages and salaries rose at their quickest pace in five years, according to a series of recent government reports. The reports suggest that troubles in housing and manufacturing, though painful for many people, have not caused the widespread economic damage that many experts had feared.
Federal Reserve policymakers held short-term interest rates steady yesterday, showing they are content -- at least for now -- with the state of the economy. They left their benchmark rate on overnight loans between banks unchanged at 5.25 percent, where it has been since June. But they indicated that they remain ready to raise borrowing costs if strong economic growth fuels a fresh bout of inflation.
President Bush hailed the news in a speech extolling the strong "state of the economy" on Wall Street, where he was also mobbed visiting the floor of the New York Stock Exchange. "As we begin this New Year, America's businesses and entrepreneurs are creating new jobs every day," he said. "Workers are making more money; their paychecks are going further. Consumers are confident, investors are optimistic."
The bright picture contrasts with the outlook of last summer, when home sales were plummeting and oil was hitting $77 a barrel. Many analysts predicted that consumer spending would stall because of costly gasoline, rising unemployment, and stagnant or falling home prices.
But the economy's buoyancy reflects two little-appreciated facts. First, the economy is less vulnerable to high oil prices than in the past, for several reasons, including improved efficiency.
Second, while the housing boom did give the economy a boost, the housing bust has not damaged the rapidly growing service industries, which employ about 80 percent of U.S. workers. And those jobs fuel consumer spending, which accounts for 70 percent of economic activity.
"This is not your grandfather's economy," said Richard Yamarone, director of economic research at Argus Research. "This is not a smokestack economy. . . . The consumer is the ultimate driver of the economy."
Economic growth did slow sharply in the spring and summer from a torrid 5.6 percent annual rate in the first three months of the year to a 2.6 percent pace in the second quarter and then 2 percent in the third quarter.
Much of the decline was accounted for by home building, which fell at a 19 percent annual rate in both the third and fourth quarters.
Nonetheless, overall economic growth rebounded in the last three months of the year, with gross domestic product, the value of all goods and services produced in the country, rising at a robust 3.5 percent annual rate.
Unemployment drifted lower through the year, to 4.5 percent in December from 4.9 percent a year earlier. The job market remained tight as employers in health, education, finance and other service industries created many more new jobs than were cut by mortgage lenders, home builders and automakers.
And the economy got a lift as oil prices tumbled to about $61 a barrel by the end of 2006 -- about where they had been a year earlier.
Drivers paying less at the pump had more to spend on shopping during the holiday season. Consumer spending rose at a blistering 4.4 percent annual rate in the last three months of the year, the Commerce Department said yesterday.
Falling oil prices helped shave the nation's import bill at year-end, and strong economic growth overseas boosted demand for U.S. exports. The Commerce Department estimated that the improvement in trade added 1.6 percentage points to the rate of economic growth in the fourth quarter.
Businesses continued to build more offices, factories and other types of nonresidential structures, helping to cushion some of the effect of the housing downturn on construction industries.
And unusually warm weather probably prompted more shopping, hiring and construction than would have occurred in colder conditions, several economists said.
Although some of the year-end momentum reflected such temporary factors, analysts said, the tight labor market bodes well for 2007.
The Commerce Department report "shows you the ability of the economy to ride out the storm of the housing market," said Wells Fargo's Alem?n. "The rest of the economy is so strong." Inflation also cooled slightly last year. Consumer prices rose 2.8 percent, a bit less than the 2.9 percent gain recorded the year before, the agency said.
Many economists seek a sense of underlying inflation by looking at so-called core inflation, which excludes volatile food and fuel prices. Core prices rose 2.1 percent in 2006 after rising 2.2 percent in 2005.
The Fed noted the improvement but said in a statement that "inflation risks remain" because of the possibility that the tight labor market will fan price pressures.
A separate Labor Department report yesterday showed that wages and salaries rose 3.2 percent last year, the fastest rate in five years.
Employers' labor costs -- including both pay and benefits -- rose 3.3 percent in 2006, up from the 3.1 percent gain in 2005.
Several analysts said the gains should not alarm the Fed. "Employers' labor costs remain moderate and do not appear to be generating inflationary pressures," said Jared Bernstein, senior economist at the Economic Policy Institute.
The economy is likely to grow about 2.4 percent this year -- more slowly than last year but at a moderately good pace -- according to the average prediction of economists surveyed by Blue Chip Indicators, a monthly publication.
Housing is likely to remain a drag on growth. Builders are still stuck with bloated inventories of unsold homes. Unemployment may rise this spring when builders break ground on far fewer new homes.
But several analysts said that despite these lingering soft spots, the Fed appears to have achieved the Holy Grail of central banking -- a "soft landing" in which it raised interest rates last year just enough to cool price pressures without triggering a recession.
Now, the central bank is likely to leave interest rates on hold for a while, said Nariman Behravesh, chief economist for Global Insight. "The Fed has the economy where it wants it."