US economy weathering credit crunch, so far

The first economic data to emerge since a credit storm walloped Wall Street last month suggest that the immediate impact on business and consumer behavior was modest.

Shoppers still filled up their carts at Target and JCPenney. Service-sector industries saw a rise in new orders. An index of manufacturing production ticked upward.

Although all this falls far short of providing an "all-clear" signal for the economy, it allows some breathing room as the world's central banks work to restore order in credit markets. The risk of recession remains very real, economists say, and they expect the Federal Reserve to act accordingly by cutting interest rates at a policy meeting Sept. 18.

"The economy looks pretty good…. It's the turmoil in the credit markets that poses a risk of taking a very good story for the economy and trashing it," says Ed Yardeni, an economist who heads Yardeni Research Inc. in Great Neck, N.Y. "It's not a widespread credit crunch yet, but it certainly has that potential."

The danger: that there will be a "contagion" effect from investor worries about the collapsing value of debt securities that are linked to tottering subprime loans. Already, in recent weeks, big investors have grown less willing to buy mortgage-backed securities or the short-term "commercial paper" debt issued by financial-service firms. Big banks, facing their own reappraisal of portfolios, have been less willing to provide short-term credit to one another.

But how much is all this affecting Main Street?

Central bankers and other economic players are closely watching indicators this week, which are the first to be released that encompass the month of August, when the credit pinch began in earnest.

So far, the indicators reveal an economy that is probably weakening, but not falling apart at the seams.

•An index of service sector-activity – most of the US economy – registered 55.8 in August, the same as in July, the Institute for Supply Management said Thursday. Any reading above 50 is considered a sign of expansion, and the August number was a bit higher than expected.

•A parallel index of manufacturing activity, released Monday, stood at 52.9 in August, down from 53.8 in July, and slightly below forecasts. Within the index, a gauge of factory output rose but new orders fell.

•Chain retail stores reported solid growth Thursday, with Wal-Mart among several whose August sales gains beat expectations.

•Automakers had a slower August than they did last year, but with the sales rate only 0.7 percent lower. For this year to date, car sales are 3 percent lower than for the same period in 2006.

•The Federal Reserve's "Beige Book," an anecdotal summary of economic conditions gathered by regional Fed banks, saw few signs of a credit crunch outside the housing sector. But while the economy is generally expanding, the pace seems to be growing more tepid in many regions.

Some pre-August numbers this week also carry weight as the Fed weighs a possible cut in its target for short-term interest rates. The overall productivity of US workers rose at a 2.6 percent annual rate in the year's second quarter, the Labor Department said Thursday. That was higher than had been originally reported, thanks to a recent upward revision in the nation's gross domestic product, to a 4 percent annual pace in the same quarter.

The improved productivity numbers give the Fed even greater leeway to cut interest rates, since inflation is less of a worry when rising output covers employers' cost of wage increases.

On Friday, another important number comes out from the Labor Department: job creation and unemployment during August.

Many economists had been expecting to see about 100,000 new jobs, but in recent days have pared down that forecast.

Moreover, layoff announcements last month were 22 percent higher than in August 2006, according to numbers tracked by Challenger, Gray & Christmas in Chicago. Some 36,000 layoffs at financial firms led the way.

"These cuts are likely to be just the beginning," said the firm's chief executive, John Challenger, in a statement this week. "The troubles in the housing sector have significant potential to reverberate beyond the financial sector."

A key risk to the economy is the twin impact of an ongoing slump in the housing market and the new shock of tightening financial conditions. If falling access to credit adds to the downward momentum of home prices, the Fed could find itself fighting deflation and recession, not inflation.

Even amid solid economic growth during this year's second quarter, consumer spending rose at just a 1.4 percent annual pace. Such worries were front and center at a recent meeting of Fed officials and economists in Jackson Hole, Wyo.

"If current conditions persist in mortgage markets, the demand for homes could weaken further, with possible implications for the broader economy," Fed Chairman Ben Bernanke said in a speech there.

So far, a full-fledged credit crunch hasn't arrived. Businesses can still issue investment-grade bonds. Stock shares haven't plunged into bear-market zone. Home buyers with good credit can still get loans, albeit by paying higher interest for jumbo mortgages over $417,000.

But stress has persisted for several weeks in short-term lending markets for so-called commercial paper. Many banks have grown less willing to make overnight loans to one another – something generally taken for granted.

That explains why the Fed and other central banks from Europe to Japan have shifted abruptly from inflation watch toward vigilance against a potential financial crisis.

Fed officials say they don't want to bail out individual firms that are in trouble. And they skipped a congressional hearing this week to avoid any appearance that political pressure might influence their Sept. 18 interest-rate decision. But most economists see little argument against a rate cut.

"With inflation so low," Mr. Yardeni says, "there's no reason for the Fed to let a recession happen."