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Next steps in question as economy cools

Sun., Aug. 13, 2006

NEW YORK – From bustling Wall Street to the quiet corridors of the Federal Reserve, there’s widespread agreement that the once-sizzling U.S. economy is slowing.

The question now is what’s next: a return to stable, modest growth or a skid into recession.

The answer will play out in the months ahead. It depends on whether soaring energy prices ease, inflation threats diminish and the slumping housing sector stabilizes or sinks.

The Mortgage Bankers Association said this month that loan applications to purchase homes in July were down 20 percent from the same month a year earlier. The National Association of Home Builders said this month that its housing-market index dipped in June to its lowest level since 1991. And the National Association of Realtors said Wednesday that existing-home sales would fall 6.5 percent this year.

Richard Berner, the chief U.S. economist for banking giant Morgan Stanley, expects the housing slowdown alone to trim U.S. economic growth by as much as 1.5 percentage points.

One troubling sign is the Realtors’ projection that the median existing-home price is expected to grow by only 4.3 percent this year, down sharply from last year’s scorching 12.2 percent.

With home price increases slowing, an important engine of U.S. consumption is sputtering. The housing boom helped drive economic growth through a combination of rapidly rising home values and historically low lending rates on refinancing and home equity loans. These led many Americans to use their homes as a sort of ATM, borrowing against their rising value to fund vacations, new cars or college tuitions. Now that may be ending.

“The U.S. is falling into a serious housing recession,” wrote Ed Yardeni, the chief analyst for institutional investor Oak Associates in Akron, Ohio, and a noted optimist. “The big question is whether the housing downturn will take the overall economy down too. I don’t think so, but several economists have been warning for quite some time that the (U.S.) economy is a house of cards.”

Recent data point decisively to an already slowing economy. Second-quarter growth slipped to a 2.5 percent annual rate after a red-hot 5.6 percent from January through March. Unemployment rose in July to 4.8 percent from 4.6 percent, and the 113,000 nonfarm jobs added in July were below expectations.

Meanwhile, oil and gasoline prices keep climbing. That threatens to keep inflation far above the Federal Reserve’s comfort zone of 1 percent to 2 percent annual growth. The Fed’s tool for combating inflation is blunt, and further interest-rate hikes that slow the already slowing economy could tip it into recession.

Higher oil prices ripple across the economy, driving up the cost of everything from gasoline to asphalt to fertilizer. Businesses pass on those costs to consumers. That’s inflation: the rise in prices across an economy.

The Fed’s primary job is to fight inflation. On Tuesday it took a pause after 17 consecutive interest rate hikes dating to June 2004. The Fed left its benchmark federal funds rate at 5.25 percent, but many financial analysts expect the soaring energy prices to drive inflation up to levels that the Fed considers intolerable.

That would force the Fed to raise lending rates even more, dampening consumer and business spending further. With economic growth already slowing sharply, that could be dangerous.

The tipping point for recession could be some supply disruption like last year’s hurricanes, which crumpled oil rigs and platforms across the Gulf of Mexico. The heart of this year’s hurricane season is upon us.

Most economic forecasters project that the U.S. economy will grow by 2.5 percent to 3 percent for the rest of this year. But almost all these models assume oil prices of $75 a barrel or less.

Should a natural disaster or a broader war in the Middle East strike, crude oil prices could race past $80 a barrel. The Fed would have to raise interest rates further to fight any resulting inflation. Recession could soon follow.

“When you pair the level of interest rates and that pressure from oil prices, it’s more pessimistic than anticipated,” said Doug Duncan, the chief economist for the Mortgage Bankers Association in Washington.

The Fed’s long series of rate hikes was designed to slow economic growth but to avoid recession, a so-called soft landing. But the cumulative effects of rate hikes lag, so the Fed’s never sure when it’s gone too far.

“The Fed does not have a great record of creating soft landings … that’s part of the reason you’re hearing pessimistic assessments,” Duncan said.


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