It Sure Looks Like a Recession

The U.S. consumer has fought the good fight, but surging prices for food and fuel, combined with falling home values and stock prices, are eroding household wealth

The drumbeat of negative economic reports in early 2008 isn't letting up. Surveys of purchasing managers show that manufacturing and nonmanufacturing activity is contracting. The drop in home sales and homebuilding is unrelenting, and house prices are falling faster, not more slowly. Now commercial construction is starting to tumble, too, as the home-mortgage mess spills over into that industry. And even as job markets weaken, higher prices are sapping consumer buying power. The message seems clear: Hopes are fading that the U.S. economy can avoid even a mild recession.

The domestic economy was already contracting in the fourth quarter. Revised data for gross domestic product still show a meager 0.6% growth rate, as first reported, but the details say that GDP, minus a 0.9-percentage-point boost from foreign trade, fell 0.3%, the first such drop in domestic activity since the 2001 recession.

Consumer Spending on the Decline

At the center of the growing pessimism is the U.S. consumer. Adjusted for inflation, consumer spending failed to grow in both December and January. The most immediate stress is lost buying power because of surging prices for food and fuel. For the past three months, consumer spending has fallen for everything except necessities. Inflation-adjusted outlays for nondiscretionary items, such as food, energy, housing, and medical care, have grown at a 3.8% annual rate. Spending on everything else, some 52% of all outlays, has fallen 1.3%.

The bigger problem is that households are losing all the cushions they have depended on in the past to absorb these kinds of blows. Up to now consumers have augmented their purchasing power by either further drawing down their savings, using credit lines, or tapping home equity or other assets.

Now, though, falling home values and stock prices are rapidly eroding household wealth. Tighter credit is limiting borrowing for big-ticket items, such as homes and cars. Revolving credit is less of an option for short-term financing because existing debt burdens are becoming more difficult to service as jobs and incomes languish. And in January the U.S. personal saving rate was –0.1%, meaning outlays were greater than income.

All Eyes on the Saving Rate

The new danger is that this decline in spendable resources will suddenly push households to increase their savings—draining even more money from the system. Yes, more saving is a long-run plus for any economy, but right now it would result in a nasty consumer-led recession. Each percentage point rise in the saving rate takes a full point off the growth of consumer spending, which is about 70% of GDP.

So far households have not shown any new caution in their savings patterns despite the intense pressure on purchasing power. Since the credit market turmoil began last summer, inflation-adjusted income has fallen, yet spending has managed to edge higher and households have continued to draw down their savings. Consumers have been able to live with skimpy savings in recent years because big gains in household assets have allowed them to spend some of their record wealth and to borrow more, all while maintaining a healthy balance sheet.

Now that's changing. Based on the current pattern of stock market losses and falling home values, household net worth is estimated to have declined by about $1 trillion in the fourth quarter and about $1.5 trillion to $2 trillion this quarter, depending on where stock prices settle. That would be the largest drop since the tech bubble burst in 2000. These sharp declines, at a time when job and income prospects are fading, are sure to add to the angst already evident in gauges of consumer confidence, which are at levels seen only in past recessions.

If consumers—and the economy—succumb, the fatal blow will most likely come from a flagging job market. Concerns there, based on reports through February, are mounting, raising the risk that consumers will have no choice in coming months but to save more and spend less.

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