By Brian Hepp

Following the significant increases in short-term interest rates by the Federal Reserve over the past two years, and given the current downturn in the domestic housing market, there’s not much question whether the U.S. economy is slowing down. The big debate now, however, is whether the country will experience a “hard” landing — in other words, a recession — or come in with a “soft” landing by slowing and posting a modest growth rate.

To understand the origins of this debate, we need to take a look at recent history to help us see where we are and how we got here. Over the past five years, the economy has fluctuated between two extremes: First, the economy was weak from 2001 to 2003 with output declining or rising slowly. From there, the economy rebounded to robust, above-average growth from 2004 through early 2006.

As the economy picked up steam in mid-2004, the Fed gradually raised interest rates to moderate growth and temper the potential for inflation. The 17 successive quarter-point interest rate hikes helped drain excess liquidity from the economy, while allowing borrowers time to adjust to tighter credit conditions. Keep in mind, the full effects of Fed tightening are usually felt about a year and a half after it takes place, so the impact of the most recent cycle — ended in June 2006 — may not be fully realized until mid-2007.

In addition to the rate hikes, several other factors have emerged over the last year that have also helped slow economic growth and increase the likelihood of a “soft” landing. First, energy prices dropped sharply during the second half of the year, enabling consumers to stretch their incomes a little further. In addition, the Fed’s interest rate hikes helped cool the overly inflated housing market. Once the weakness in the housing sector became pronounced, the Fed stopped raising interest rates, at least for the time being.

In the meantime, also lending credence to the “soft” landing scenario is the fact that corporate profits have continued to grow, giving companies sufficient funds to expand payrolls and increase capital spending. This will help sustain economic growth, albeit at a more modest and manageable pace.

It’s important to remember, however, is that geopolitical events are always a factor when looking at the prospects for the economy. With the current challenges facing our country — the conflict in Iraq, the resurgence of the Taliban in Afghanistan, and the nuclear ambitions of Iran and North Korea — the probability of an adverse geopolitical event that could jolt the economy and bring about a hard landing has probably increased.

All things considered, absent a major geopolitical event, we expect a “soft” landing for the economy in the year ahead with economic growth moderating — not stalling. For more information about the outlook for the coming year, A.G. Edwards has recently published its annual Investment Guide, which includes the firm’s outlook in these and other areas — including fixed-income research, currency and debt analysis, equity and fixed-income portfolio strategies, and securities research. Copies of the report are available on the Web site, agedwards.com/fc/brian.hepp, or by calling the office.

Brian Hepp is a financial consultant for Santa Monica-based A.G. Edwards & Sons, Inc. Member SIPC. He can be reached at (310) 453-0077 or at brian.hepp@agedwards.com.