On Guard Against Recession

All signs suggest meager growthif thatin the fourth quarter, with little improvement in early 2008. So the Fed is taking preemptive action

The goods news: The government says the economy grew 3.9% in the third quarter. The bad news: That's the last of the good news on growth. In the fourth quarter, look for the full brunt of the credit crunch, the latest downturn in the housing slump, $90-a-barrel oil, and growing caution by consumers and businesses to take their tolls. Most economists expect growth of only 1% to 2% this quarter, with little improvement in early 2008, and many of those folks have their fingers crossed. The risks to that somber forecast are almost all to the downside.

It is the unknowns that prompted the Federal Reserve to take out some more recession insurance on Oct. 31 by lopping a quarter-point off its target interest rate, bringing it to 4.5%. Whether the economy will be derailed by the tighter financial conditions caused by the mortgage-related turmoil in the credit markets remains the biggest unknown. Federal Reserve Chairman Ben S. Bernanke and other influential policymakers have noted recently that in times of high uncertainty, strong, preemptive action may be the right policy to prevent broad damage to the economy.

Credit markets are stable but still fragile. Through Oct. 24, the volume of asset-backed commercial paper outstanding, much of it mortgage-related, shrank further as investors continued to back away. That lack of funding raises worries that banks will get stuck with more problem assets that would erode their balance sheets and limit lending. Banks have almost certainly tightened their lending standards since July; the question is by how much. The Fed's quarterly survey of senior loan officers, which is usually released in early November, will offer an important indication. Credit is the lifeblood of business. If credit constraints lead to any retrenchment in corporate spending or hiring, the hit to the economy could be hard.

So Far, Demand Outside of Housing Has Held Up
The Fed's cut, along with the hefty 3.9% advance in last quarter's real gross domestic product, offers hope that the economy will muddle through. The GDP data show demand outside of housing has held firm. A sharp drop in residential construction subtracted a percentage point from GDP growth. Still, consumer spending posted a healthy gain, business investment rose solidly, and an export-driven narrowing in the trade deficit made a big contribution.

The problem is that the third quarter started strong but finished much weaker, with manufacturing, hiring, and confidence on the wane. The Conference Board's October index of consumer confidence dropped for the third month in a row, to a two-year low, partly reflecting job worries.

And that was before oil hit $90. Regular gas was up 10 cents per gallon nationally, to $2.87 during October, with higher prices ahead. Costlier energy will bite deeply into consumer purchasing power this quarter, and falling home prices will rob household wealth. The drop in the Standard & Poor's (MHP ) Case-Shiller price index for 20 cities accelerated in August, bringing the decline since the July, 2006, peak to 4.5%. That's about half of what most analysts ultimately expect.

Business confidence is also slipping, which puts capital spending and payroll gains at risk. Companies are hesitant to commit money to new projects. Orders for capital goods other than aircraft have stagnated since April, and production of business equipment has made no progress since July. A credit squeeze could be one reason. Yield spreads between investment-grade corporate bonds and riskless Treasury notes, a gauge of investors' risk aversion, remain wide, even for AAA-rated companies.

Many businesses are showing good third-quarter earnings; they're just wary about spending them. BusinessWeek data on 738 companies' profits as of Oct. 30 show net income down 6% from a year ago. But excluding 144 firms in the banking, financial, and durable consumer-goods industries (which includes homebuilders), profits are up 8%.

Amid the uncertainty over how the housing slump, credit crunch, and costly energy will play out, one thing is clear: The economy's resilience will be sorely tested in coming months, and the Fed's work may not yet be done.

By James C. Cooper

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