Profile of a (maybe) recession

Optimism has grown this month that the United States may escape a recession. But don't haul out the ticker tape just yet.

The current economic slowdown is unusual – and difficult to read – because the housing market is playing such a central role.

Alongside high oil prices and a credit squeeze, a downturn in homebuilding and home prices has rattled consumer confidence, which fell Tuesday to a 16-year low. That prompts many economists to say a recession is still likely.

Yet housing cycles historically have been slow, taking years on both the up and down side. Moreover, the decline in housing wealth doesn't cause an equal or immediate decline in consumer spending. This may portend a kind of slow-motion slump, one that may not even end up officially as a recession.

"We are not going to have a recession this time. This time the troubles in housing will stay in housing," predicts Edward Leamer, director of the Anderson Forecast at the University of California, Los Angeles. "[But] it's harder to forecast because something new is happening this time."

It's common, he says, for housing to be one of the sectors hit early and hard by an economic downturn. And the current housing downturn is unusually deep. Home prices are down 14.1 percent in the past year, according to the Standard & Poor's Case-Shiller index, released Tuesday.

But recessions involve a sharp slowdown in economic activity well beyond housing and construction. Mr. Leamer says that the manufacturing sector generally plays the pivotal role, in terms of job losses, during recessions. After the last US recession, which occurred in 2001, US factories never went on a hiring spree, and this year's economic slowdown so far hasn't spawned manufacturing layoffs at typical recession rates.

Housing's fallout

Still, the housing downturn has not only cost lots of construction and banking jobs. Through home-price declines, it's also devouring trillions of dollars in consumer wealth – which in recent years had been a source of cash through home-equity loans and "cash-out" refinancing of mortgages.

That could make it hard for the economy to enter a strong growth phase.

"The second half [of this year] will not be a return to normal, and neither will 2009, basically because the consumer who was the driving force is going to be sitting on sidelines," Leamer predicts.

The crunch doesn't affect everyone equally. Some families are hard-hit by mortgage rate resets for example, while millions of others are renters or people who own homes without a mortgage.

But housing troubles could make it hard for consumers overall to spend a lot more, even if they don't dramatically cut spending.

Hence the uncertainty: Will this even end up as a recession?

A panel of economists is watching what happens now, and will ultimately have to make that call.

Members of the panel caution against reading too much into the fact that GDP didn't turn negative in the preliminary first-quarter numbers released at the end of April.

"Employment is falling," says Jeffrey Frankel, one of seven members of the business cycle dating committee, an arm of the private National Bureau of Economic Research.

It may be that a recession has simply been postponed, not avoided, he says.

Mr. Frankel, a Harvard University economist, notes that the housing slump is one of several forces buffeting consumers.

Other negatives:

•Energy and food prices have soared.

•Bank credit conditions are tightening.

•The lost housing wealth not only crimps access to home-equity loans, but it also adds pressure on workers to save for retirement. The house is no longer as big of a nest egg.

"There's every reason to think that the household is going to have to cut back on consumption," Frankel says.

Still, he says it's conceivable that a recession could be avoided.

"We're very cautious and wait until everything is finished," before deciding that a recession began in a certain month, he says.

What might balance all the negative forces?

The natural tendency of the economy is to grow, as businesses invest in new ventures, banks make loans, and consumers spend. Recessions often happen when several major obstacles arise at once – a policy mistake by the Federal Reserve, a "shock" such as a spike in oil prices, or imbalances such as a run-up in product inventories.

In the current cycle, the big imbalance in the domestic economy centered on housing. Homebuilders are correcting by retrenching rapidly, but inventories of for-sale homes remain large.

Some economists also say the Fed made a mistake of waiting too long to boost interest rates as a "bubble" began to build in home prices – a bubble that was biggest in coastal and Sun Belt markets.

But in recent months, the Fed has responded vigorously to the threat of recession, cutting interest rates and extending loans to help banks weather hard times. Congress and President Bush also moved quickly to stimulate the economy with fiscal policy – tax rebate checks that are starting to arrive this month.

The policy response could help the economy skate through much of the year without a declining quarter for GDP.

An economy on edge

Often, a shorthand definition of recession is two quarters where GDP falls. The National Bureau's business cycle dating committee doesn't have such a specific criteria. On its website, the group says there must be a "a significant decline in economic activity" for more than a few months, visible in several indicators beyond just GDP.

Right now, those indicators show an economy on the edge.

A comparison of activity levels now with three months before show that three indicators declined, while two others are up. GDP, measured quarterly, is rising at a 0.6 percent annual rate. The amount of inflation-adjusted income in the economy is also rising. (But in a worrisome counterpoint, average non-supervisory wages haven't been keeping pace with inflation over the past year.)

Employment, industrial production, retail sales all show declines.

Jobs often hold the key. So far, the labor market hasn't deteriorated as sharply as it has heading into past recessions, but the trend also doesn't look encouraging. A weak job market has contributed to recent declines in consumer confidence. The continuing run-up in oil prices is also hammering consumers. It acts like a tax, as energy expenses leave people with less to spend elsewhere in the economy.

And housing remains a great source of uncertainty.

Like all typical housing cycles, the current one involves big swings in home construction and home sales. The decline in home sales this time looks similar to what happened back in 1990 and 1991, for example.

But it's unusual to see such a sharp plunge in prices. "Everything hinges on what's going to happen to house prices," Martin Feldstein, another Harvard economist who sits on the dating committee, said recently in a Bloomberg TV interview.

Property values need to adjust to balance supply and demand. But banks and consumers could be hit harder, he says, if prices "spiral down … into an overshoot position."