The Fed's Race Against Recession

It has cut interest rates sharply, but banks and other lenders aren't playing along. And the dip in January payrolls suggests growing weakness in the service sector

Going into the last week in January, economy watchers were expecting a blitz of reports to shed some light on the overarching question of the day: Are we in a recession? Fresh data on everything from housing and manufacturing to the labor markets and gross domestic product failed to answer the question definitively, but they tended to lean more toward the downside than the upside. What the latest indicators do say clearly is that U.S. economic growth essentially ground to a halt in the fourth quarter of last year, and it appears to be no better than dead in the water in the first quarter.

Which way the economy goes from here, either up or down, will most likely be decided by the severity of the credit squeeze that began last year, and the news from that front is not good. The Federal Reserve has cut interest rates aggressively in an effort to offset the tightening of financial conditions caused by less available credit. But the cost of credit is not the biggest issue. Lenders are increasingly unwilling to provide loans because they perceive greater risk and uncertainty in doing so.

Despite the Fed's sharp cuts, rates on investment-grade corporate bonds have not come down much, and they remain high relative to Treasury yields, indicating investors' reduced appetite for risk. Banks are also increasingly stingy, as bad loans weaken balance sheets and, thus, the capacity and willingness to lend. In January banks further tightened their lending standards across nearly all loan types, even as borrowing demand weakened, according to the Fed's latest survey.

Those results, which most likely influenced the Fed's recent rate cuts, showed 32% of U.S. banks and twice as many foreign lenders demanded tougher terms and conditions on commercial and industrial loans to large and midsize companies, up from 19% in October. For small companies, 30% tightened their standards, up from 10%. Problems in the home mortgage market, where lending was also stricter, have spilled into commercial real estate, where 80% of banks raised the bar on new loans, the most since the survey began in 1990.

Both consumers and businesses are affected by tighter credit, but the impact on the business sector is more important. Credit is critical to corporate expansion, and expansion is what generates jobs and incomes for households. That means a key place to find recession clues will be the job markets, which are the crucial link between business activity and consumer income. The yearly growth rate of payrolls tracks the pace of capital spending just as closely as it does the growth in real wage-and-salary income.

That linkage is especially important right now, since consumers were the economy's linchpin throughout 2007, contributing more than 90% of last year's 2.2% annual growth rate. Despite the headwinds from soaring gas prices, falling home values, and stock market volatility, it was steady growth in jobs and incomes, as businesses continued to expand, that kept consumers spending—much more so than easy credit.

That's why the 17,000-job dip in January payrolls deserves special attention. That decline, combined with the January plunge in the Institute for Supply Management's index of nonmanufacturing activity, suggests growing weakness in the service sector. Over the past year services have been the engine of job growth, accounting for all of the net gains in payrolls, even as jobs in manufacturing and construction have fallen. In January private-sector service jobs rose a scant 52,000, less than half the average monthly gain in the prior six months. The slowdown was concentrated in business and professional services.

Weaker job markets, especially the new softness in services, are a sure sign that many businesses are starting to cut back, most likely amid economic uncertainty and stricter limits on credit. The trouble is, banks and credit markets appear to be tightening financial conditions faster than the Fed's rate cuts can loosen them up.

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