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U.S.: The Credit Squeeze Is Starting To Pinch

Business Outlook: U.S. ECONOMY


Heavier borrowing costs are another weight on the economy's shoulders

In one crucial way, the coming economic slowdown is similar to those of the past: Credit is getting tighter. The big difference is that the Federal Reserve did not trigger the tightening. This time, with a nudge from chillier financial conditions abroad, the financial markets themselves did the dirty deed.

Nevertheless, the impact on the U.S. economy will be the same. Domestic demand in credit-sensitive sectors--capital spending, consumer outlays for big-ticket items, and housing--will take the biggest hit. Also, the $1.5 trillion loss in net wealth since mid-July will be felt to some extent in overall consumer spending and housing. Even Federal Reserve Chairman Alan Greenspan recognized that the sharp runup in stock prices "has been a major factor galvanizing consumer expenditures and holding up housing sales." Now, though, some of that support is gone.

The current credit squeeze and loss of wealth are two reasons some economists are raising the probability of a recession in their 1999 forecasts. Use of the "R" word still seems premature, but clearly, all eyes will be watching the data for signs of just how much the economy is slowing. What should grab the biggest attention? The indicators on future domestic demand. Such diverse data as capital-goods orders, jobless claims, consumer confidence, and mortgage applications will be the numbers to watch.

WHY HAVE FINANCIAL CONDITIONS changed so sharply? After years of soaring stock prices and free-flowing credit, investors suddenly decided that the world was a much riskier place than they had thought (chart). Greenspan himself has acknowledged that the financial-market imbalances arose in large part because investors had begun to underestimate greatly the risk associated with stocks and bonds.

As far back as December, 1996, when Greenspan questioned the stock market's "irrational exuberance," his concern was based on the fact that various measures of risk tolerance, including yield spreads and equity premiums, had fallen to negligible levels. A combination of Asia's crisis, sagging U.S. profits, the Russian debt default, and U.S. political uncertainty is what woke investors up.

What is happening now, Greenspan says, "is a major shift toward risk aversion pretty much throughout the world." At the same time, commercial banks are starting to tighten up what had been fairly lax lending standards, especially for businesses. The result: The cost of capital is rising on two fronts. Borrowing in the credit markets is more expensive, and amid sagging stock prices, equity capital is dearer as well.

The credit squeeze shows up in the yield spreads between corporate debt issues and riskless Treasury bonds. For example, the spread between moderately risky BAA-rated corporates and 30-year Treasuries has soared in recent weeks to levels not seen since the 1990-91 recession. The spread even for top-quality AAA-rated corporates has widened. The AAA yield has declined, but Treasuries have fallen much more.

THE HIGHER COST OF CAPITAL makes capital spending, a key force in this business cycle, the most vulnerable sector in the economy right now. That's especially true since weak profits continue to limit the ability of companies to finance their equipment and construction projects internally.

How companies place new orders will contain the most information on how much damage this unwinding of financial-market excesses is doing. Through August, capital-goods orders have been holding up. But the critical months are those upcoming, as businesses digest the latest round of financial-market tightening.

The other crucial sector is, of course, household spending. As they almost always do, consumers will determine the degree of the economy's slowdown. They have lost some confidence, but as strong September car buying and a rise in retail sales show, they are still shopping (chart). September retail buying rose 0.3%, and third-quarter real consumer spending appears to have grown at a solid 3% pace.

Amid excellent income growth and big wealth gains from the past surge in stock prices and mortgage refinancings, households have been able to handle fairly high debt burdens and an extremely low savings rate. Also, while debt service costs for installment debt as a percentage of income have climbed far above the late- 1980s level, overall debt service is below the 198

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