For decision??“makers the fraternal twin challenges of below trend growth and above target inflation suggest a strategy of caution and balance sheet repair at this stage of the business cycle. During the typical mid-cycle of an economic expansion, slower growth is not unusual, but what is unusual is the length of the current period of below trend growth. Higher inflation is also not unusual, but this time the pace of inflation remains above the Federal Reserve??™s target ceiling and that closes the door on any easing unless the economy weakens even more. Challenges remain.

U.S. economic growth should benefit from modest gains in consumer spending although such gains have been limited by the weaker housing market and cutbacks in the domestic motor vehicle industry. Corporate profit growth has also slowed, thereby, weakening investment spending.

Government spending continues to benefit from tax revenues based on strong income gains. Net exports are expected to contribute positively to growth in 2007 as well. Real GDP is expected to be up 2.3 percent this year compared to 3.3 percent last year.

The major downside risk to the economy continues to be the housing sector. We expect the bulk of the decline in residential construction to be behind us by the middle of this year. In addition, inventories should be a drag on growth all year. Interest rates and the inverted yield curve will limit growth. As such, the Federal Reserve will likely hold interest rates steady this year.

Foreign Economic Growth Remains Solid

Recent data suggest economic growth in the rest of the world has slowed somewhat over the past few months, but growth rates generally remain solid. Not only is monetary policy in most foreign countries not overly restrictive yet, but the forces of globalization are helping to lift real income in many emerging economies.

There are two implications of strong growth in the rest of the world. First, U.S. export growth should remain solid. Although the external sector probably will not contribute as much to overall U.S. real GDP growth as it did in the fourth quarter anytime soon, net exports probably won??™t exert a significant drag on the U.S. economy either. The second implication is that central banks in major foreign economies will likely tighten further. Indeed, we look for both the ECB and the Bank of England to hike rates again by 25 basis points this quarter. The Bank of Japan will likely tighten further, albeit at a very gradual pace.

With the Fed on hold, interest rate differentials between the United States and the rest of the world should narrow further, which will likely erode the relative attractiveness of U.S. fixed income securities. Although the U.S. current account deficit should narrow somewhat in the quarters ahead, it will still require very large net capital inflows simply to keep the dollar steady. That seems like a tall order in an environment of narrowing interest rate differentials.

Hence, we look for the greenback to trend lower versus most major currencies in the quarters ahead.

Economic Workout Continues

Just as a company working through past excesses, the economy continues to work through its overspending on housing as well as secular shift in the auto industry and demographic changes.

During the first half of 2007, housing should remain a significant drag on the economy. Real GDP is expected to grow two percent during the first half of the year and a bit stronger in the second half, as the negative growth implications of housing diminish. Unfortunately, we do not expect core inflation to moderate, as rising labor compensation costs and declining productivity, both typical of the mid-cycle economy, conspire to raise prices.

Domestic Demand

Consumer spending growth should benefit from continued real income gains and the improvement in consumer psychology due to a tight labor market.

Employment and income growth should remain relatively solid. After expanding at 3.3 percent last year we expect personal consumption expenditures (PCE) to rise more than three percent this year. Spending for motor vehicles and other big-ticket items is expected to moderate over the course of 2007, which should help push the saving rate up from its record lows hit this past year.

Business fixed investment has weakened sharply especially equipment and software spending. Two fundamentals--slower final sales growth and reduced corporate profit growth--do suggest slower investment. On the plus side, capacity utilization and capital costs remain favorable. In recent quarters, the weakness in business equipment spending does appear to have declined more than fundamentals suggest. Our outlook for steady gains in capital spending for 2007 would require a pick-up in orders and shipments of non-defense capital goods in the months ahead.

Government spending will also provide a slight boost to overall growth in the coming year. State and local government budgets have improved dramatically over the past year. Many have held back on major infrastructure projects due to sharply higher construction costs. With costs having moderated in recent months, many projects will now likely move forward.

Net Exports: A Plus for Growth and an Opportunity

Overlooked in all the pessimism about housing is the strength of export demand and the likely positive add to growth from net exports. The globalization of capital markets and product markets suggests new opportunities for business leaders ahead.

Interest Rates and Credit Risks

Slower economic and profit growth, along with the slide in the housing market, indicate a higher risk profile for creditors. Credit spreads have widened and delinquencies on subprime mortgages have surged in recent months. Given the above target pace of inflation, we do not expect any Fed easing this year. This leaves us with a flat-toinverted yield curve all year. So far, there has been little overt tightening in lending standards by private banks, yet some tightening is clearly coming. Tighter lending standards will shrink the availability of mortgage and business lending credit, which will moderate any gains in housing and business investment this year. We remain cautious on the credit front this year with the bias that credit issues should limit the pace of the recovery.