[O]ur baseline forecast sees soft economic activity this fall; notably, it is likely that a further sharp decline in residential investment will weigh on the top-line growth numbers. But we see growth recovering next year and moving up to average close to potential later in 2008, which we at the Chicago Fed currently see as being somewhat above 2-1/2 percent. This lower potential number in part reflects an assumed trend in productivity growth that is slower than the trend we experienced over the 1995-2003 period. Nonetheless, the new productivity trend is still a healthy one by longer-term historical standards and, accordingly, should support income creation, job growth, and household and business spending. Solid demand for our exports should also be a plus for growth. Although we expect a small increase in the unemployment rate, labor markets in general should remain healthy. Indeed, on balance, I would characterize the data we have received on the real economy since the last FOMC meeting as supporting our baseline forecast.

 It is noteworthy that we saw a significant reduction in the trade deficit in the fourth quarter of 2006. Exports grew at a very robust 8.4 percent pace, while imports expanded by just 1.2 percent during the second half of the year. This shift in the direction of net exports has been driven primarily by two factors. First is the strong economic growth of our trading partners. Europe and Japan have been experiencing stronger than expected growth, and other nations such as China have been growing very rapidly. This growth in the world economy boosts demand for our exports. Second, the recent declines in the value of the dollar have made our exports cheaper on the world market and at the same time made imports more expensive here in the U.S. While there is no guarantee these trends will carry over into 2007, the signs are encouraging.

Globally, growth is solid as well. U.S. exports have increased and trade is at least for now marginally supportive of growth. 

Growth of the global economy will help support US economic activity by continuing to stimulate demand for our exports of goods and services.

Central banks in a number of other industiralized countries are currently tightening policy, and slower growth abroad could limit some of the anticipated improvements in US exports over the next year.

On the business side, I look for capital spending to continue to expand at a decent pace again this year. Stronger economic growth abroad will also boost American exports. These two sectors - business spending and exports - are likely to mitigate the effects of a slowdown in the consumer and housing sectors.

Globally, output growth appears poised to exceed 4 percent for the fourth consecutive year--a strong performance that will support the US economy by continuing to stimulate our exports of goods and services.

To be sure, most forecasters are expecting the overall pace of economic activity to moderate to a more sustainable pace in coming quarters as housing markets gradually cool and the delayed effects of higher interest rates and energy prices temper domestic demand. However, with economic activity abroad expanding at a solid pace, export sales should provide some support for domestic production.

Investors seem to expect short-term interest rates to remain on the low side of historical averages for some time. These subdued expectations may reflect a belief that underlying global demand will remain damped and that the world will continue to be willing to invest heavily in the United States.

By reducing the need for domestic production of goods and services, the trade deficit subtracted about three quarters of a percentage point from real GDP growth in the first half of this year. Whether the trade gap will narrow depends—in part—on the strength of economic growth among our trading partners, because that affects demand for our exports. However, most of our major trading partners have had only moderate growth recently. So long as these conditions prevail, they won’t provide much impetus for growth in our own economy.

The limited evidence since the November easing has supported our view that the U.S. economy has been working its way through a soft patch. And the patch has certainly been soft. The labor market has remained subdued, as businesses apparently have been reluctant to add to payrolls. The manufacturing sector remains especially damped, and nonresidential construction has trended lower. By all reports, state and local governments continue to struggle with deterioration in their fiscal conditions. Oil prices have recently risen and, not least, the economies of most of our major trading partners have shown little vigor.

With the welcome recovery of foreign economies and with the leveling out of the dollar, these factors holding down demand and prices in the United States started to unwind. Strong growth in foreign economic activity is expected to continue this year, and, other things equal, the effect of the previous appreciation of the dollar should wane, augmenting demand on U.S. resources and lessening one source of downward pressure on our prices.

Should the situation abroad remain unsettled, these factors would probably continue to contribute to good price performance in the United States in the period ahead. But it is important to recognize that the damping influence of these factors on inflation is mostly temporary. At some point, the dollar will stop rising, foreign demand will begin to recover, and oil and other commodity prices will stop falling and could even back up some. Indeed, a brisk snap-back in foreign economic activity, should that occur, would add, at least temporarily, to price pressures in the United States.