What will send the U.S. into recession?

What will send the U.S. into recession? [¹]
A growing cadre sees it happening, but economy gets better at dodging bullet

By Rex Nutting, MarketWatch | October 2007

WASHINGTON (MarketWatch)— Ben Bernanke faces his toughest challenge: Keeping the economy from slipping into recession, while at the same time allowing the markets to sort out the winners and losers of the housing and credit bubbles.

With job growth upended, the housing market still sinking fast, and credit problems mounting on Wall Street, a growing number of economists say the risks are growing that a recession will hit the U.S. economy in the next 12 months.

Even Federal Reserve officials are sounding the alarm.

"I think the probability of recession is higher than it used to be," said St. Louis Fed President William Poole in a conversation with reporters in London on Thursday.

The majority of economists, however, say the economy will weather this storm, as it almost always does. It's hard to put the resilient U.S. economy into a recession, they say. Over the past 17 years, the economy has been in recession for just eight months. That's less than 4% of the time.

The U.S. economy is extremely diverse. A slump in one sector or region can be offset by growth elsewhere. The economy is also less prone to recession than it used to be. As the economy has moved away from relying on cyclical industries, such as agriculture, mining and manufacturing, to more stable services, recessions have become less frequent and shallower.

'Sinking ship'

The way economists see it, there's only about a 35% chance of a recession in the next year, according to the median estimate of 25 economists surveyed by MarketWatch this past week prior to Friday's employment report. That's up from about a 23% chance estimated by economists surveyed by the Blue Chip Economic Indicators in early July, but it's still well below 50%.

It may be comforting to know that the odds are still tilted against a recession, until you remember that the economics profession as a whole has never predicted a recession. How to define a recession anyway?

One reason economists assign such a low probability to a recession is that they expect the Fed to act forcefully to prevent it, by lowering the federal funds rate.

"A recession is still avoidable in my opinion, but the Fed will need to act promptly and with authority to right this sinking ship," said Scott Anderson, a senior economist for Wells Fargo.

The idea behind a Fed rate cut is that lower interest rates could prop up the housing market just enough to avoid a big increase in foreclosures and layoffs from construction companies. In the short run, lower rates could also boost liquidity and confidence in financial markets, which would also lead to more borrowing and spending.

But critics say the Fed's rate cuts can't produce a miracle.

The credit crunch on Wall Street reflects an unwillingness to lend because of a lack of trust, not a lack of funds. Until the markets get rid of the chaff, the price of credit isn't going to be that important.

Allergy

So far, the Panic of 2007 isn't like your grandfather's recession. Credit Suisse economist Neal Soss calls it "a new allergy to structured finance."

"You're not going to cure that with a cut in the federal funds rate," Soss said.

The most prominent exponent of the "recession is coming" view is Martin Feldstein, one of the grand old lions of macroeconomics, who spoke to all the Federal Reserve policy-makers at the last Jackson Hole retreat weekend.

When Feldstein told them was that the problems in housing "point to a potentially serious decline in aggregate demand and economic activity," you can bet they listened, even if they didn't fully agree.

Feldstein told the Fed officials that they should cut the federal funds target rate immediately by as much as a full percentage point, and even that wouldn't be guaranteed to work.

Economist Edward Leamer of UCLA told the same gathering that economic forecasters have systematically ignored the primary role of housing in the business cycle. Of the past 10 recessions, eight have been preceded by overinvestment and then a slump in housing, Leamer said. Housing isn't just some fringe part of the economy, but a major driver of the business cycle, Leamer argued.

Feldstein says that the housing sector is at the root of three major concerns, any one of which could significantly slow economic growth.

First, he said, the drop in home prices has devastated the home-building sector, costing thousands of jobs and slicing output. The decline in residential investment has shaved about 1 percentage point off growth in each of the past two years.

Second, the collapse of the subprime-mortgage industry has spiraled into a wider credit squeeze, hurting the ability for companies outside of mortgage and housing businesses to obtain the credits they need to operate.

The consumer

Third, consumer spending could be reduced significantly by the inability of homeowners to borrow against their home equity, closing off what has been a big source of disposable income for consumers.

There's not much disagreement about Feldstein's first point— that home building has been a big drag on the economy. It's his other two points that are debatable. So far, there's little evidence that the problems in the credit markets have had any impact on the ability of consumers or companies to get credit, outside of mortgages. But if the problems persist, the crunch could hurt the broader economy.

Bernanke agreed with Feldstein, up to a point.

In his speech at the Jackson Hole conference, the Fed chairman said that if the credit crunch didn't ease, then "the current weakness in housing could be deeper or more prolonged than previously expected, with possible adverse effects on consumer spending and the economy more generally."

There's a big disagreement among economists about the role of mortgage-equity withdrawal in consumer spending over the past five years. Contrary to Feldstein's position, some don't believe it's had any impact at all.

Investors will find out soon enough, because equity-takeout mortgages are now "officially dead," according to Alec Crawford, a market strategist in mortgage-backed securities for RBS Greenwich Capital. What makes this episode different is that the inventory overhang isn't just in physical assets, such as houses, cars and widgets. It's also in complex financial instruments, which are so novel that no one really knows how to liquidate them.

"Lenders have been flushing assets into the financial system's plumbing like there is no tomorrow," said Anderson, the Wells Fargo economist. "But now that plumbing system is backing up, and if lenders and the Fed aren't careful, they will be left with a hell of a mess to clean up."


Normxxx    
______________

The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.