Forecast 2007: The economy

NEW YORK (Money Magazine) -- Change goes with the territory in the U.S. economy, and if change makes you nervous, 2007 could be a trying year.

In just the past few months, half a dozen of the trends that defined the economic environment in recent years either have reversed themselves or appear on the verge. Interest rates stopped climbing at midyear. Oil is off 24 percent from its July peak. The real estate boom, much as home sellers would like to deny it, is over.

And the economy, which since 2003 had been pounding out growth like an Ohio State fullback, suddenly wilted to a 1.6 percent annual rate in the third quarter.

What's it all mean to your money? Simple: The two-year battle between the Federal Reserve and inflation is over, and the Fed won.

Inflation-loving assets like gold, oil and center-hall colonials are in for a rough patch.

But blue-chip growth stocks finally have a chance to thrive.

This suggests a pretty clear course of action for your money over the coming year, which you'll see spelled out in the rest of this special report. But before you make any moves, make sure you're comfortable with the economic argument here.

How can you be sure, for example, that inflation is truly back in its cage? How can you be sure we don't instead end up with inflation and a stagnant economy (not exactly an environment in which financial assets have thrived in the past)?

Well, you can never be totally sure in forecasting, but the worst-case scenario really doesn't appear to be in the cards today. The bitter 1970s stagflation occurred when high oil prices depressed the economy and fueled inflation at the same time. But oil prices today have been falling, not rising, since peaking in July at $78 a barrel.

Part of the run-up to the peak was driven by supply and demand, but it was greatly exaggerated by companies hoarding oil in case of runaway prices and by speculators looking to make a killing. (Strictly on the basis of supply and demand, economists say, the fair price is around $50.)

Now that the peak in prices appears to be behind us, much of that hoard is being sold, even as producers keep drilling new wells.

The result: more supply, slower growth in demand and, hence, lower prices. When a similar reversal happened after the 1970s oil crisis, oil fell from $77 (in today's dollars) to less than $20. The coming decline surely won't be that severe - there could even be brief upticks - but in the next few years, prices will likely fall below $50.

And if there's no upward spiral in oil prices, it's hard to see where more inflation would come from. Consumer prices that only a few months ago were rising at 5 percent are now moving up at a 2 percent or 3 percent pace. Wage increases, an essential step in the classic cycle of inflation, are barely to be seen. Despite an unemployment rate of just 4.4 percent, the lowest in five years, there's simply too much competition in the global labor market to give workers the power to bargain for raises big enough to fuel serious inflation.

Most important, the economy is expected to cool, not heat up.A decelerating economy exerts a powerful downdraft on prices for materials and labor. And if prices are soft, it takes an outside shock like terrorists destroying oil facilities to cause inflation.

What if the economy cools too much? Obviously something put the brakes on economic growth this fall. How can you be sure those forces won't drag the economy all the way to recession in 2007?

The answer is that we already know what forces are causing the economy's growth to slow: the Federal Reserve's 17 consecutive hikes in short-term interest rates and the downturn in the housing market. Yes, the combination will likely slow growth into the second half of 2007, but neither is drastic enough to outweigh all that the economy has going for it. The Fed, after all, stopped raising rates five months ago, and although there could be another hike, by next spring Fed chairman Ben Bernanke is likely to be bringing rates down. The real estate downturn is unpleasant, to be sure, if you work in construction or have to sell your house in a rush. But the housing bubble hasn't burst; it seems to be slowly deflating. The economy can handle that.

And there are plenty of positive factors to offset the housing downturn. Low unemployment means consumers still have money to spend. The rate increases of the past two years may continue to squeeze homeowners who have adjustable-rate mortgages, but the worst is over and some of those borrowers will be able to refinance into fixed-rate mortgages. Inflation never reached intolerable levels, and corporate profit growth has been above average for most of the past three years. Those are the characteristics of a healthy economy, not the signs of an expansion on its last legs.

Another important signal is that the stock market is upbeat. For more than a year, the Dow Jones industrial average barely budged, since investors could see that the Fed would have to slow the economy's growth to get inflation under control. But stocks never took the kind of header that usually precedes a recession.

Now the Fed has done its work, and the Dow has responded by climbing to record highs. That's a sign that investors are convinced inflation has been tamed, that interest rates will eventually drop and that even if profit growth slows during the next three or four quarters, it will revive within a year.

Far from being the leading edge of recession, in the market's view, a go-slow economy is good news. By bleeding off the inflationary pressures built up after three years of expansion, it will help sustain the recovery for longer than would otherwise have been possible.

By no measure, of course, is 2007 going to be the best of all possible worlds. In a weak economy, decent salary increases will be hard to come by for yet another year. And a low-inflation, slow-growth economy won't do anything to reverse the bear market in real estate.

But from your point of view as the owner of a 401(k), bank accounts, stocks and other financial assets, 2007 will have a lot going for it. To take advantage, see our "Best Ideas" for next year.