U.S. Economy was Remarkably Strong in 2005:

During 2005, the news media was full of stories about economic disasters. High energy prices were supposed to hurt consumer spending. High interest rates were going to burst the housing bubble. Then came hurricane Katrina. And Rita. The winds and flooding were going to impact everything from energy to coffee prices.

What did happen to the U.S. economy? From the latest quarterly data on growth rates for Gross Domestic Product, we can see that there was no noticeable deterioration (Figure 1). Obviously, the U.S. economy was stronger than anybody anticipated.

Hurricane Impacts

2005 was the year of the weather. Just how do events like hurricanes Katrina and Rita impact the U.S. economy? It's not the wind speed or the rain that matter, but where the hurricane hits.

The city of New Orleans was directly in the path of Katrina. New Orleans had about 1.3 million people, accounting for about 0.5 percent of the country's GDE These people haven't been working, and these goods and services haven't been produced since last September. And they probably will not be back in service for many more months.

This is a direct loss to the U.S. economy. For example, personal income in Louisiana dropped by $32 million, or 25 percent, between the second and third quarters of 2005.

Rita had a much smaller impact. The Beaumont-Lake Charles area is a much smaller economic area. They have only about a half million people and were shut down for about a week.

The story would have been very different if Rita went 70 miles to the west. Then it would have hit Houston, and Rita would have had a much greater impact than Katrina.

The hurricanes also had indirect impacts, primarily on energy prices. The Gulf Coast is a major source of crude oil and natural gas. There are also a number of refineries in the area. Both Katrina and Rita caused supply-induced shocks. There were reductions in crude oil, refined products, and natural gas. We know what happens when supply goes down. Prices go up.

The important thing about a supply shock is that it is over once the supply is resumed. So supply shocks tend to be relatively short. And that's what happened here. The price of gasoline reached $3 a gallon last fall, but then dropped to pre-hurricane levels as the refineries resumed production.

In short, then, six months after these disastrous hurricanes, we are left with the direct impacts on New Orleans. The indirect impacts on energy are mostly over, and the forecasts for 2006 are quite optimistic.

So, here are our Top 10 economic predictions for 2006, courtesy of Global Insight Inc.:

1. Solid growth will last for at least another year. In the United States, an expected slowdown in consumer spending and housing will be offset by strength in capital spending and exports, helped by a fiscal boost from hurricane-related construction.

2. The United States will, once again, outpace Europe and Japan. Japan's growth spurt may sputter, the European Central Bank (ECB) raised interest rates, and German fiscal policy is turning restrictive.

3. China and the rest of Asia (except Japan) will remain the star performers in the global economy. Growth in China cools (8.4 percent vs. 9.3 percent) while India and South Korea continue to expand rapidly.

4. Oil prices will slide gradually, but the risks are on the upside.

5. Core U.S. inflation will edge upward. Productivity growth stays strong and compensation increases are still tame, therefore, inflation is unlikely to get out of control.

6. The Fed will keep tightening monetary policy through the spring. Global Insight Inc. predicts a 4.75 percent Federal Funds rate by mid'2006, and then the Fed will take a breather.

7. House prices will level off without crashing. British and Australian housing markets have already cooled without crashing.

8. The U.S. current account deficit will plumb new depths - again. The inflow of investment from rest of the world continues.

9. The U.S. dollar will end the year lower than at the start.

10. There will be no recession in the next couple of years without the convergence of two or more big shocks. What would it take to trigger a recession? Answer: the combination of oil prices greater than $100/barrel, interest rates 3 percentage points above current levels, and a 10 percent drop in home prices. All possible, but unlikely in 2006 or 2007.