by Bill Dunkelberg - NFIB 
For small businesses, 2006 was a good year. Owners sensed the pickup in economic activity before the year started, as the Index of Small Business Optimism jumped to 103 in October 2005 (1986=100), a sign that the first quarter of 2006 was going to be very strong. Indeed, growth in the first quarter accelerated to almost 6 percent at an annual rate, nearly doubling the trend growth rate. Mid-year, optimism faded a bit, signaling a slower economy. And, sure enough, the Optimism Index averaged 98 in the second half.

So what is the economic outlook for 2007? With the new year in full swing, we take a look at how some of the biggest economic factors will influence small business this year:

Declining housing market: In some part of the country, housing was the hot ticket in 2006, especially condos. Construction boomed, fueled by low interest rates, strong employment growth and a flood of investment money (foreign and domestic) looking for an alternative to recent years' disappointing stock markets, which themselves have now reached new record levels.

Places such as Southern California, Las Vegas, Florida and costal communities experienced bubble-like increases in home prices last year, and a surge in new home construction. But following usual historical patterns, the industry built houses faster than the growth in real owners, and a glut ensued, contributing to the slowing of the economy. Overall though, the housing market adjustments appear to be proceeding in an orderly way, posing little threat of major destabilization this year.

Labor markets: The most impressive development in the second half of 2006 was the strength of labor markets. The unemployment rate has held at historically low rates (around 4.5 percent), and the percent of the adult population with a job is at a near record high level (63.3 percent, exceeded only by readings in the dot-com era).

Nearly one in five owners plan to increase employment at their firms this year, and one in five has one or more job openings they can't fill. The availability of qualified workers is so serious that one in 10 owners report this as their most important business problem—ranking it ahead of energy, taxes or health-care costs.

In the second half of 2006, more than half of owners reported trying to hire each month, with more than 80 percent of these owners reporting few or no qualified workers for their open positions. As a result, the percent of owners reporting higher worker compensation remained high all throughout last year. Though Congress may disagree, a higher minimum wage will not help the situation. Instead a wage hike will reduce job opportunities and raise the cost of labor for the same work effort.

Inflation: On the inflation front, performance has not been as good from the Fed's perspective, although owners are always appreciative of any price increases they can maintain. The percent of owners raising prices (net of those cutting selling prices) rose to a high of 26 percent in April 2006. Since then, the frequency of reported price hikes has declined to the mid-teens, good news for the inflation fighters, but not good enough to get the core inflation rate into the Fed's desired target range, which is less than 2 percent. In 2003, the inflation rate was 2 percent, and the net percent of firms raising selling prices averaged 3 percent--far below recent readings of 17 percent. Even with declines in construction prices, too many firms are still successfully raising prices to allow the Fed to declare victory. This leads many observers to expect further Fed rate hikes, although I am not in that camp.

Two months into 2007, the good news is that none of the Small Business Indicators are out of bounds, neither up nor down. That may be boring, but steady growth around 3 percent with modest inflation and solid employment will be welcome, adding 2007 to a string of good years building the current expansion.