Get Ready for a Second-Half Squeeze

The U.S. economy has held up remarkably well so far this year despite terrible conditions, but the rest of 2008 will be even tougher as businesses and consumers tighten their belts

The economy's buoyancy in the first half of 2008 has been remarkable. Earlier this year, the thought that growth could average 2.1% annually would have seemed out of touch with the realities of financial market stress, tighter borrowing conditions, falling home values, and shrinking payrolls. Nevertheless, after posting a 0.9% advance in the first quarter, the economy charged ahead at a 3.3% clip in the second quarter, a steep upward revision from the government's original estimate of 1.9%. No, all this does not mean it's O.K. to breathe easier. Staying afloat in the second half is going to be a much more difficult challenge.

First, the lift from foreign trade, accounting for more than 90% of first-half growth, will be much smaller. Growth in Britain ground to a halt last quarter, the euro zone contracted, as did Japan, and growth elsewhere has slowed a notch. More troubling, outside of foreign trade, the domestic economy shrank in the fourth quarter, stayed almost flat for the next two, and is set to weaken further.

The focus in the second half will be on consumers and jobs. Households contributed modestly to overall growth in the first half, as real (or inflation-adjusted) purchases rose 0.9% and 1.7% annually in the first and second quarters, respectively. But spending is getting off to an ominously poor start in the third quarter. Monthly declines in both June and July already have put outlays in a deep hole. It would take sizable gains in both August and September to prevent real consumer spending from recording its first quarterly decline since 1991.

Through July, consumers' biggest problem was rising gasoline prices. Despite job losses, the labor markets and the tax rebates gave households enough income to increase their spending at a hefty 6.8% annual rate in the three months through July, up sharply from 3.8% in the previous three months. But that's before accounting for rising prices. From April to July, 56% of the increase in spending went to buy gas and other energy. After taking inflation into account, that 6.8% jump turns into a 0.7% drop.

In the second half, falling gas prices, which by late August were 10% below their July peak, will help to restore some lost buying power. Still, it will take an additional 15% drop to get pump prices back to where they were earlier this year, and by the fourth quarter the spending boost from the tax rebates will be but a memory.

The new problem is income growth. The strong-looking numbers on the overall economy belie progressively slower income gains for both households and businesses. The government revised down its earlier estimates of wage-and-salary income in the first half, and it reported a fourth consecutive quarterly drop in corporate profits.

So far this year, income growth from wages and salaries has slowed to 2.9% annually, from 4.5% during 2007. Even excluding energy, consumer prices are rising faster than that. The pay slowdown reflects losses in jobs and hours worked, which may well intensify in the second half.

That's because businesses are feeling the pressure from the weak domestic economy. The drop in profits reflects not only sagging demand but declining margins. For nonfinancial companies, the profit from each unit of output is falling sharply. Companies are getting hit with the increasing cost of energy and other materials, many of which are imports whose prices are rising rapidly.

This squeeze is likely to crimp both capital spending and consumer demand, as companies try to limit the damage to profitability by postponing projects and cutting more jobs. So far, as strong productivity has helped businesses cope with weak demand and rising costs, consumers have not suffered as badly as in past recessions, when job and income losses were much more severe. The danger in the second half is that companies will step up their cost-cutting, further undermining consumer spending and overall economic growth.

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