The Economy's Next Bogey: Consumer Belt-Tightening

Housing led the U.S. economy's first decline. Now the plunge in consumer spendingthe worst in nearly three decadesaugurs unpleasant quarters to come

A clearer picture of the economy's plight is now coming into focus, and it's not a pretty sight. Recent data confirm that consumers and businesses were already retrenching before the market turmoil began with the Sept. 15 bankruptcy of Lehman Brothers. Now, the subsequent widespread disruptions in the credit and equity markets have greatly accelerated those pullbacks, darkening the near-term outlook and retarding prospects for recovery. True, credit markets are beginning to thaw around the edges, but the bad news for the economy is: Too much damage has already been done.

Up to now, the economy's troubles have been largely housing-led, with homebuilding alone subtracting a full percentage point from overall growth over the past year, while consumers and businesses managed to keep their heads above water. Not anymore. This new, more ominous phase of weakness is consumer-driven, and it includes a transformation in consumer behavior that will weigh on spending growth throughout 2009.

Federal Reserve Chairman Ben Bernanke didn't use the R-word in his Oct. 20 congressional testimony, but his message rang of recession. He said the economy is likely to be weak for several quarters, with some risk of a protracted slowdown. Private economists are more direct. They expect a dip in third-quarter real gross domestic product, to be reported on Oct. 30, and foresee it being followed by larger contractions this quarter and next.

Last quarter's plunge in consumer spending was staggering. Surprisingly weak retail sales imply that inflation-adjusted consumer spending declined four months in a row, from June through September. For the quarter, spending fell some 3% annually, possibly the largest decline since the Carter Administration's credit controls in early 1980. Plus, October consumer outlays are certain to start the fourth quarter below the third-quarter average. That foreshadows another drop this quarter, especially given October's record plunge in consumer sentiment.

Falling oil prices will help, but they are no panacea. Oil is now about half its $145-per-barrel peak in July, knocking more than $1 off the price of a gallon of gas. Economists at UBS (UBS) note that because U.S. households buy about 100 billion gallons of gas per year, a dollar-a-gallon drop in pump prices, if sustained, would free up some $100 billion for spending. That's about as much stimulus as this year's tax rebates. Another Washington stimulus package, endorsed by Bernanke in his Oct. 20 testimony, appears on the way, but any benefits are unlikely to be felt before well into next year.

Losses in jobs and income will depress consumer spending for most of 2009, as businesses cut back in response to new weakness in demand, tight credit, and an unusually uncertain outlook. Early-bird readings on October business activity lurched downward in the Philadelphia and New York Federal Reserve districts. The Philly Fed reported that many companies were having trouble securing credit to finance their operations, and 43% of the businesses surveyed were cutting their capital spending.

Longer term, the impact on consumer spending will come from the new savings imperative, a result of fading support from easy credit and household wealth. Big gains in stocks and home values in earlier years gave consumers both the wherewithal to increase their debt and an alternative to saving from their incomes. That's why the savings rate fell to zero. Through the third quarter, wealth losses over the previous 12 months surpassed $4 trillion, even before the October swoon. Neither those losses nor easy credit will come back anytime soon. Next year, more of the growth in household income will have to go to savings, leaving less room for growth in spending.

None of this rules out a modest economic recovery later next year. As credit begins to flow normally, interest rates will fall, housing's drag will ease, and consumers will start spending again—but at a much more subdued rate than in recent years.

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