We at the Chicago Fed think that after a strong rebound in the first quarter of 2006, real GDP growth will average somewhat above three percent over the next couple of years. We expect that the unemployment rate will change little from its current level and that inflation will remain contained. However, inflation currently is near the upper end of the range that I feel is consistent with price stability. As such, I believe monetary policy must be vigilant. We need to make sure that increases in resource utilization or prices of energy and other commodities do not add to inflationary pressures or increase inflation expectations.

Much of this decline [in fourth quarter 2005 GDP growth], however, reflects fluctuations in government spending, imports, and motor vehicle output that look to have been temporary. Indeed, the most recent monthly indicators of activity have been favorable, and we think that growth in output is rebounding smartly from the low fourth-quarter number.

Growth is proceeding on a solid pace this year, and inflation is low and stable. Moreover, our economy has withstood several substantial shocks over the last several years, and yet has remained on course. So, I think we have abundant reason to be grateful for a quite positive economic outlook.

If we are at all accurate, 2006 will be a year of solid growth, perhaps faster in the first half as Katrina rebuilding occurs and energy prices stabilize, and slower later on as hurricane-related fiscal stimulus ebbs and housing activity tapers off, but strong overall.

My best guess is that a good part of this strength is the flip-side of the factors that made the economy weak in the fourth quarter, and therefore should not be extrapolated to subsequent quarters. Therefore, it seems likely that growth will settle back to a trend-like pattern as the year progresses. One likely contributing factor is the winding down of the rebuilding effort later in the year. Another is the lagged effect of monetary policy tightening; in other words, tighter financial conditions will have a dampening impact on interest-sensitive sectors, such as consumer durables, housing, and business investment.

A risk to the U.S. forecast would come from a significant reversal of the boom in house prices, which could have a very restrictive impact, especially through negative wealth effects. However, so far, I’d say that we’ve only seen early signs of a cooling off in U.S. housing markets.

I’m not convinced that foreign capacity is a major reason to shrug off concerns about the possibility of overshooting capacity in U.S. labor and product markets. And, as I’ve said, it appears that the economy is near full usage of resources, but it’s not clear whether we are slightly above capacity or below.

While we face a great deal of uncertainty, the economy appears to be approaching a highly desirable glide path. First, real GDP growth currently appears to be quite strong, but there is good reason to expect it to slow to around its potential rate as the year progresses. Second, it appears that we are operating in the vicinity of “full employment” with a variety of indicators giving only moderately different signals. Finally, inflation is near the high end of my comfort zone, but it appears well contained at present, and my best guess for the future is that it will remain well contained.

GDP grew at only about 1.6 percent in the fourth quarter last year—about half the pace of the previous 2 ½ years. The analysis done by my staff and others suggests this relatively weak reading was an aberration that does not imply a loss of momentum going forward.

Overall, the fundamentals appear sufficient to support continued economic expansion. Underlying productivity growth remains strong, the financial positions of households and businesses remain conducive to spending, and, if we have no further run-up in oil prices, the drag on activity from higher energy prices should diminish over time.

All told, the U.S. economic expansion appears to be solidly on track. Nevertheless, the outlook for real activity faces a number of significant risks, including the possibility that house prices and construction could retrench sharply and that energy prices could rise significantly further.

Although they are imprecise, simulations from the Federal Reserve Board staff's large-scale econometric model, which account for these effects, suggest that increases in spot and futures prices of energy from late 2003 to the present subtracted a 1/2 percentage point from real GDP growth in 2004 and more than 1 percentage point in 2005. The model suggests the subtraction this year will be about a 1/2 percentage point.

Nevertheless, the risk exists that, with aggregate demand exhibiting considerable momentum, output could overshoot its sustainable path, leading ultimately--in the absence of countervailing monetary policy action--to further upward pressure on inflation. In these circumstances, the FOMC judged that some further firming of monetary policy may be necessary, an assessment with which I concur.

Our economy continues to steam along at a pace that the consensus of economists estimates will be somewhere north of 4 percent in this current quarter, after netting out inflation, which we have maintained at or near the 2 percent level despite record-high energy prices.

[GDP growth] slowed to a still solid 3.5 percent in 2005, although I would not be surprised if GDP were revised upward when we take a more definitive look at the fourth quarter.