Expectations for below-trend economic growth due to high energy costs, rising interest rates, a slump in the housing market and lower consumer spending proved to be too pessimistic for 2006. Gross domestic product-the broadest measure of the nation's output of goods and services adjusted for inflation-rose 3.4 percent, more than the 3.1 percent average growth rate over the past 10 years. The unemployment rate, which was expected to rise over the course of the year, fell to 4.5 percent from 4.9 percent at the beginning of the year. Inflation, as measured by the Consumer Price Index-the government's broadest gauge of costs of goods and services-declined to 2.5 percent from 3.4 percent, primarily due to the fall in energy prices. Oil reached a peak of just over $77 per barrel in 2006 but ended the year a little over $61 a barrel, only a penny ahead of the price at last year's close. With a moderating inflation rate, the Federal Reserve maintained a steady interest rate policy in the second half of the year, pausing after 17 consecutive 0.25 percent rate hikes. Corporate profits continued to expand at double-digit rates.

The combination of these positive factors, as well as strong merger and acquisition activity, set the stage for above-trend equity performance both in the U.S. and abroad. The Standard & Poor's (S&P) 500 returned 15.8 percent (including reinvested dividends), with most of the surge coming in the second half of the year. Interest rates rose during the year, with most of the rise coming in the closing weeks of the year. In 2006, the two-year U.S. Treasury note increased in yield from 4.4 percent to 4.8 percent, while the 30-year U.S. Treasury bond rose from 4.5 percent to 4.8 percent. With yields rising (and hence bond prices falling), the Lehman Brothers Government/Credit Index, our proxy for measuring the performance of bonds, returned 3.8 percent. Bond returns were held in check as sentiment among bond investors seesawed between the need for further rate increases and optimism for rate cuts. The decline in bond prices at year-end signaled the evaporation of investor expectations for interest rate cuts early in 2007.

Looking Forward

After averaging growth of 3.4 percent over the last four years, the economy is expected to grow at a slower pace in 2007, with forecasts calling for a 2.5 percent to 3.0 percent growth rate. Economists expect the unemployment rate to gradually rise to 4.8 percent to 5.0 percent. A three and a half (31/2) year run of double digit increases in corporate earnings is expected to end as corporate profits decline in a slower growth environment. Inflation is expected to continue to moderate, with the core rate eventually moving below 2 percent, the upper limit of the Federal Reserve's comfort zone. If inflation develops as expected, the Federal Reserve could maintain a steady interest rate policy for much of 2007.