A crossroads for the U.S. economy

Chart showing what forecasters are predicting for an economy that grew 2 to 2.5 percent, a slower pace than in the first quarter.
By Neil Irwin
Washington Post Staff Writer
Thursday, July 29, 2010

The U.S. economy is out of the ditch. But is there enough gas left in the engine to reach highway speed?

The recovery faces a crucial test over the next couple of months: Either it will pick up vital momentum from increased consumer spending and investment or stall out, dipping into a period of anemic growth -- or perhaps even another recession.

Forecasters knew this inflection point would arrive, a moment when consumers and businesses must take over for government stimulus spending and the rebuilding of inventories.

On Friday, the government will offer crucial evidence when it reports on second-quarter economic growth. This will be the first in a series of indicators in the coming weeks that could help answer whether the economy has achieved cruising speed, in particular whether the private sector is growing fast enough to put unemployed Americans back to work. Forecasters are expecting that gross domestic product rose at a rate of 2 to 2.5 percent rate in the April-through-June quarter, which would be too slow to drive down the jobless rate.

Just Wednesday, the government announced a surprising 1 percent drop in June orders for durable goods and a compilation of anecdotal reports from around the country by the Federal Reserve showed a recovery that is increasingly uneven. This fit into the pattern of recent economic indicators showing that the transition to a self-sustaining recovery has been rocky.

Fits and starts are common during early stages of economic expansion. Before long, it should be clear whether the summer of 2010 has indeed been a mere soft patch as recovery took hold.

"We're right on the cusp between simply decelerating and actually falling into a double dip," said Robert A. Johnson, executive director of the Institute for New Economic Thinking. "We have households still trying to be cautious and improve their savings, and if they cut back further, it will create a feedback loop that drives us back down."

It was barely a year ago that the economy made the transition from steep contraction toward expansion. Simultaneously, a gush of federal stimulus money started spreading through the economy. Government backstops for the financial system helped instill confidence that the system wouldn't collapse. An aggressive series of interest rate cuts and other actions by the Federal Reserve took effect. All those factors helped ease the fear of economic collapse that earlier weighed on businesses considering investment decisions and consumers thinking of purchases.

Now, though the impact of the fiscal stimulus continues to be felt, it is tapering off, no longer adding to growth.

At the same time, a one-time boost to growth from business inventories is also ending. During the depths of the recession, companies reduced their production even more than consumers pulled back, depleting their inventories. The need to replenish those inventories contributed to growth in late 2009 and early 2010.

Economists and policymakers have been counting on the inventory bounce and stimulus priming the pump, helping create a self-sustaining momentum. Those temporary factors, goes the logic, should make consumers more confident about making major purchases, which in turn increases demand for products, leading businesses to ramp up production and hire more employees. That should result in higher incomes and even more consumer confidence, fueling a virtuous cycle.

But that cycle could sputter if Americans, groaning under the weight of household debt run up during the past decade, decide they would rather pay it down instead of increasing their spending.

Americans remain deeply uncertain about the economic future. A Conference Board survey showed they are actually less confident about the economy now than they were last August, when the expansion had just begun.

True double-dip recessions -- a second extended contraction in economic activity -- are rare, historically. But economic activity wouldn't need to contract for joblessness to remain high.

The economy's natural growth rate, due to population growth and technological improvements, is 2.5 to 3 percent a year. So any extended period of growth much below that, say 1 to 2 percent, would drive unemployment up.

And while many economists now argue that the odds of a dip back into recession have increased in the past couple of months, fewer say it's probable.

"It seems extremely unlikely to me that we would have a true double dip," said Joseph E. Gagnon, a senior fellow at the Peterson Institute for International Economics. "But a period of sub-par growth would be not at all surprising and may even be the most likely possibility."

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