US forecast: Can consumers rescue the new year?

US economic growth will be within a forecasting error of recession for the next three quarters as the effective cost of capital remains high.
The US economy is on the brink of recession. We now expect economic growth to average near 1% for the next three quarters (the fourth quarter of 2007 through the second quarter of 2008). This is well within the forecasting error of recession, despite the Federal Reserve's recent rate cuts.

The housing decline will have its biggest negative impact during this period, and orders data suggest slower capital spending. To a large extent, however, the distinction is more semantic than real. The slowdown will feel like a recession to most people.

The two sectors keeping the economy out of recession are foreign trade and consumer spending. The continued growth in the rest of the world has helped close the US trade deficit, offsetting much of the effect of falling housing starts. However, the increased competition from the US is hurting Europe, with the trade surplus of the Euro zone shifting into deficit. So far, the Asian and Latin American economies remain strong.

The US slowdown has had little effect on the growth in China and India, as trade patterns have shifted toward more intra-Asian trade and away from exports to the US. We expect some slowdown next year, but the weaker dollar should still propel US exports and continue to close the trade gap.

The more serious issue is consumer spending. Households are being squeezed between lower home prices and higher energy costs. Savings rates remain low, and with baby boomers rapidly marching toward the cliff of retirement, little time is left to save. Confidence has been hit by the weaker housing market and other problems, further suggesting to households that saving might be a good idea. We expect a continued slowdown in consumer spending after the holidays.

The Federal Reserve is reacting to the risk of recession by lowering interest rates, cutting the federal funds rate again on December 11 by 25 basis points to 4.25%. Another cut is expected at the next meeting of the Federal Open Market Committee (FOMC) at the end of January. But the widening quality spreads in lending markets mean that the cost of borrowing to individuals and firms has actually increased.

The Fed rate cuts have partially offset the implicit tightening caused by the change in risk perceptions, but have not lowered the effective cost of capital. As an effort to control borrowing costs more directly, the Fed has announced a new Term Auction Facility (TAF).

Wealth and debt

Household wealth is being diminished by the drop in home prices. Fortunately, stock prices remain firm, but household net worth dropped to 571.7% of income in the third quarter from 574.1% in the second quarter, according to the Federal Reserve's flow of funds data. The net-worth ratio remains high above any seen before 1996, but the decline may give households pause.

The drop in home prices has also increased the overall loan-to-value ratio in the US housing market. The outstanding mortgage balance rose 1.8% in the third quarter, to $10.4 trillion, but the ratio of mortgage balance to the market value of homes rose to 49.6% from 48.9% in the second quarter of 2007 and 47.6% in the third quarter of 2006.

The overall ratio has been rising slowly over the past several years (from 43.9% in 2002), but has jumped much more sharply recently as mortgage debt has risen, while the value of homes has stopped increasing. The homeowners' equity in their homes dropped $129 billion in the third quarter to $10.6 trillion.

Household debt has continued to rise, reaching $14.2 trillion in the third quarter, or a record 138% of household disposable income, up from 113% in 2002. Non-mortgage debt rose to $3.49 trillion (34.1% of disposable income) from $3.45 trillion (34.2%) in the second quarter and from $3.26 trillion (33.7%) a year ago.

In addition, non-mortgage debt has been relatively stable as a share of income over the past few years (it was 33.5% in 2002). However, we fear that part of the reason for the stability is that households have been refinancing their credit-card debt into mortgages and home-equity loans. That play is coming to an end, because home prices are no longer rising and mortgages and home-equity loans are more difficult to obtain.

Household wealth is expected to decline relative to income, further slowing consumer spending. The rising asset values in recent years have allowed Americans to feel that saving is unnecessary, with the familiar retort that their assets are doing their savings for them. Now, the value of the household's portfolio is declining and wealth is dropping. Individuals for whom retirement is looming will need to start saving quickly.

Except for mortgages, problems in handling debt seem limited. This shouldn't be surprising because the run-up in the debt/income ratio is so concentrated in mortgage debt. Credit-card losses have risen to 4.4% in October, from 3.8% a year earlier. However, losses remain well below the historical average of 5.2% (since 1990) and the 6.7% average from 2001-2005. The bankruptcy-law change in October 2005 caused a surge of bankruptcies, followed by a sharp tumble. Car loan defaults, however, have moved higher, particularly on subprime auto loans.

The biggest impact, of course, has been on mortgage delinquencies, which have reached 20-year highs. The Mortgage Bankers' Association reported that 5.59% of all mortgages were delinquent at the end of the third quarter, the highest level since 1986. The rate is up from 4.67% a year earlier. The percentage of loans in foreclosure rose to a record 1.69%, up from 1.05% a year earlier. Most of the problem is in adjustable-rate mortgages, mainly in the subprime sector. The continued foreclosures will depress home prices.

Treasury Secretary Hank Paulson has convinced lenders to freeze mortgage payments for many subprime borrowers, which should alleviate some problems. At least, it will avert the fire sales that would otherwise result from the wave of foreclosures. Although some investors are complaining that they are being forced to give up the higher rates to which they hold contracts, this solution is clearly less painful than foreclosures would be. The trick will be to confine the benefits to only owner-occupied housing and cut out investment and speculative properties.

The agreement does not fix the fundamental problem, however. We built too many houses that were too expensive. Home prices must decline to levels more consistent with incomes, and the number of starts has to drop far enough for long enough to clear out the inventory of excess homes. We expect housing starts to hit the bottom next spring, at just under one million units, and we expect home prices to drop another 6% (following their 4.9% drop over the latest 12 months) by late next year.Energy and consumers

On the other side of the squeeze are energy prices. Oil prices flirted with $100/bbl before dropping back to $90. Our forecast is for prices to continue to slide to $75/bbl in 2009. As usual, our confidence in that forecast is low. Although the balance of supply and demand suggests that oil prices should drop, the realities of Middle Eastern politics suggest they could just as easily jump.

The good news is that oil prices don't matter as much as they used to. Energy spending will be 5.6% of average household income in 2008, down from 5.8% in 2007, but up from 4.2% in 2002. In 1981, energy was 8.0% of household income. Energy prices are certainly a drag on growth, but not nearly the drag that they were in the 1980-1981 energy crisis.

The extent of the drag will depend on the weather. The critical quarter is the first quarter of 2008, the peak period for heating. So far, weather has been a bit worse than normal in November and early December, but January and February will likely see the most energy use. In addition, most homeowners get hit with these costs with a lag; we tend not to think too much about the heat when we are using it, only when we get the bill the following month. A warm winter could both help lower fuel prices and reduce use enough to offset the higher prices.

Where's the rest of my present?

The markets reacted to the Fed's quarter-point rate cut like a bratty five-year-old at Christmas. The quarter-point cut was treated like a lump of coal, because markets had talked themselves into a half-point cut. A majority of economists had said that they expected only a quarter point, but the whispers on the street were that the Fed would do more.

It didn't. Stock prices dropped 2% after the release of the FOMC statement on the afternoon of December 11. The language of the press release, although it seems to us to clearly indicate further rate cuts, was deemed less aggressive than the markets desired. However, the announcement of the TAF on December 12 convinced markets that the Fed was not ignoring the financial problems and stocks recovered much of the losses of the previous day.

We expect the Federal Reserve to cut rates again in January to 4% and probably to 3.5% by April. Ben Bernanke has not been chairman long enough for us to know his style. Chairman Greenspan often punctuated the end of a rate cycle with a larger move, which could come in March. Alternatively, we could see quarter-point cuts extending to the April meeting. Usually the Fed prefers to be inactive during a presidential campaign, so they would like to get the rate cuts over before the summer.

The problem for the Fed remains the disorderly financial markets. While some parts of the credit markets are becoming less blocked, many lending categories, including most structured finance instruments, are trading at high spreads against Treasury securities. Although the federal funds rate has been cut to 4.25%, the cost of borrowing has risen for most corporations and individuals because of higher spreads. The three-month euro-dollar rate has been trading 75 bps above the federal funds rate and the spread between the three-month euro-dollar rate and the three-month Treasury yield has widened to 219 bps from 37 bps a year ago. These costs determine private borrowing, and the increases suggest sluggish growth for capital spending and a continued decline in housing.

If nothing else goes wrong, we still expect the economy to escape recession. However, there is little room for error, with both the fourth and first quarters now expected to show growth of less than 1%. Any other problems ù a new oil price surge, further disorder in the financial markets, or a related decline in inflows of capital from outside the US ù will turn this bumpy landing into a recession.

David Wyss is Standard & Poor's chief economist, based in New York.
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