Clouds Added to Many Economic Forecasts

By Nell Henderson
Washington Post Staff Writer
Friday, March 2, 2007

A few weeks ago, Wall Street was praising the Federal Reserve for cooling the economy just enough to tame inflation without chilling it into a recession. Now, after several days of financial market turmoil and conflicting economic reports, analysts are having second thoughts.

Yesterday, several said they saw rising risks of higher inflation and much weaker economic growth.

Consumer prices jumped in January, while home construction fell sharply, the Commerce Department reported yesterday. That combined with falling stock prices, distress in some credit markets and declining business investment to sour many forecasts.

"I think the odds of a recession have gone up in the last two weeks," said David Shulman, a senior economist with the Anderson Forecast at the University of California at Los Angeles.

But more-optimistic observers pointed yesterday to a Commerce Department report that consumer spending, which accounts for two-thirds of the nation's economic activity, rose briskly in January, while incomes climbed even more rapidly.

The nation's factories also produced more goods, hired more workers and booked more new orders in February, the Institute for Supply Management, a business association, said yesterday.

And the labor market remains tight, with unemployment at a low 4.6 percent in January, though many forecasters expect that rate to edge higher in coming months.

"I think that overall the economy is in great shape," said Bernard Baumohl, managing director of the Economic Outlook Group, who argues that buoyant consumer spending will more than offset the economy's soft spots.

The disagreement is typical of a time when the figures are mixed, and it is unclear how consumers will respond to falling stock prices. If consumers pull back now, the economy is likely to falter, several analysts said.

That hasn't happened yet. Consumer spending rose 0.3 percent in January, after adjusting for inflation, fueled by a 0.5 percent increase in after-tax income.

Before adjusting for taxes and inflation, personal income rose 1 percent in January, the fastest rate in a year, partly reflecting big bonus payments, stock market gains and pay raises for federal workers, the Commerce Department said.

This fits with Fed Chairman Ben S. Bernanke's statement Wednesday that the central bank still foresees moderate economic growth this year -- about 2.5 to 3 percent. That would be slower than last year's 3.3 percent expansion but enough to keep unemployment low.

Bernanke's predecessor, Alan Greenspan, said Monday in remarks to a private group that a recession is possible later this year -- words that contributed to the stock market sell-off Tuesday. On Wednesday, he stressed to another group that he does not see a recession as likely -- a view similar to the Fed's and many other forecasts.

And in a speech in Washington, Treasury Secretary Henry M. Paulson Jr. said, "I am watching developments carefully, and I believe that the U.S. economy is healthy."

The latest inflation figures, however, did not match the Fed's forecast of diminishing price pressures. Core inflation, which excludes volatile food and energy prices, rose 0.3 percent in January, the fastest rate since August, and was up 2.3 percent from a year earlier, the Commerce Department said. Bernanke and other Fed policymakers have said they prefer to keep price increases in a range of 1 to 2 percent annually.

The Institute for Supply Management's report also showed that manufacturers paid higher prices for raw materials in February.

Rising inflation and a danger of slower economic growth put the Fed in a bind. Central bank policymakers restrain price increases by raising interest rates, making it harder for businesses and consumers to borrow and spend, which dampens demand; it responds to weak growth by cutting rates, which has the opposite effect.

Bernanke told Congress last month that the Fed thought it could probably hold its benchmark short-term interest rate steady for a while because it expects slower growth to lower inflation. But he also warned that if price pressures pick up, he and his colleagues would raise the rate.

Raising the short-term rate now, however, would make it harder for borrowers with adjustable-rate mortgages to refinance their loans. That would exacerbate the credit crunch in the market for loans to subprime borrowers, who have lower incomes and poor credit histories. Delinquencies and defaults on those loans have risen sharply in recent months, causing some lenders to go out of business.

The UCLA Anderson Forecast is lowering its expectations for economic growth primarily because it thinks the turmoil in the subprime mortgage market will prolong and deepen the housing slump, Shulman said. The group won't release its updated forecast until April but anticipates that defaults will rise, increasing the number of homes for sale, while lenders make fewer loans, reducing the number of buyers.

Investors in futures contracts increased their bets yesterday that the central bank will cut interest rates by summer, which might help the subprime market.

But cutting rates might also spur inflation higher, a danger that may strengthen the Fed's case for leaving policy on hold for now.

The Fed does not have to do anything to lower long-term interest rates, such as on fixed-rate mortgages, which are determined in global financial markets. Long-term rates are already falling because investors are moving their money out of stocks and into much safer Treasury securities, pushing down their yields, which serve as benchmarks for private debt. For example, the interest rate on a 30-year, fixed-rate mortgage is linked to the yield on the 10-year Treasury bond, which has tumbled over the past week.

Interest rates have been historically low in recent months but not low enough to stimulate business spending on new plants, equipment and computers. Such capital investment spending declined in late 2006 and in January, according to two recent Commerce Department reports.

The institute's report on increased factory orders in February may signal a rebound in business spending but not a lot of momentum overall, said Brian Bethune, an economist at Global Insight. He attributes this to caution among the nation's chief executives because of the economic slowdown, rising prices and uncertainty about whether customer demand will hold up.

These factors "have got those

CEOs on tenterhooks right now," Bethune said.

Weak business investment and declining stock prices are among the reasons Global Insight now sees the odds of a recession as 15 to 20 percent, up from about 10 percent last week, Bethune said.

These odds, he said, "are not high, but they're not trivial."