U.S. economy runs too hot and too cold - Is recession or inflation a bigger risk?

U.S. economy runs too hot and too cold - Is recession or inflation a bigger risk?
By Eduardo Porter
Copyright by The International Herald Tribune
Published: December 26, 2006


NEW YORK: Economists have long waxed lyrical about a "Goldilocks economy" — one that is not too hot, not too cold.

In this ideal world, the U.S. economy is running so smoothly that there is little risk of it overheating and pushing inflation higher — something that would force the Federal Reserve to raise interest rates. Nor is the job market weakening, threatening to plunge the economy into the icy bath of a recession.

The "just right" economy is not often achieved, of course, but lately this bedtime story has taken a particularly tricky turn: it is both too hot and too cold.

The U.S. housing market has fallen into a deep freeze; so has the auto industry. Yet on several other fronts, including commercial construction and high-end consumer spending, economic activity appears to be sizzling.

Lombard Street Research, a British economic forecasting firm, recently called the American economy the "anti- Goldilocks economy."

That is making it challenging for both economists and the Fed to decide which risk is greater: that housing will drag down the rest of the economy, pushing the Fed to cut rates, or that inflation will remain above the Fed's comfort zone, forcing it to push up rates instead.

But others say that next year, hot and cold could end up canceling each other out, turning the economy balmy.

For now, though, with home construction entering its second year of a downturn, many economists have aggressively pared back their forecasts for growth in 2007. Some have even started to utter the "R word."

"We've increased the probability of a recession in our forecast to 35 percent," said David Berson, chief economist of Fannie Mae, the leading U.S. source for home mortgage financing.

On the other hand, Charles Dumas, who follows the American economy for Lombard in London, ticked off a list of countervailing forces, from high employment and income growth to robust business investment. "None of that speaks of a slowdown," he said.

The economy looks very different depending on whether you are inside or outside the housing market.

Consider Andrew Palau, who runs Premier Homes & Additions in River Edge, New Jersey. Business has dried up as the slump in the housing market has reduced demand for new master bathrooms and refurbished kitchens.

"Homeowners don't have a clear view in front of them, so they are not investing, because they want to hold on to the money," Palau said.

He managed to hold on to his staff of 10 this year, but he said he probably would have to let some people go next year. "Everything is telling me that next year will be worse," he said.

Virtually every home builder in the United States shares Palau's concern. Yet a look just outside the border of the housing-linked economy provides a starkly different view.

"Our market is as close to capacity as you can get," said Michael Bolen, chairman and chief executive of McCarthy Building in St. Louis, Missouri, a commercial builder of properties ranging from schools and hospitals to casinos and parking lots.

To hear Bolen speak, the job market has the go-go feel of the Internet-driven boom of the late 1990s. "It's as goofy as it's ever been," he said. "We're offering signing bonuses and guaranteed locations to people coming straight out of school."

Bolen said McCarthy expected to increase its hourly work force of 1,800 by 10 percent to 15 percent when the construction season picked up in the spring. This off-kilter performance has allowed for an unusually wide difference of views on the economic outlook for next year.

Ian Shepherdson, chief economist at High Frequency Economics in Valhalla, New York, expects the economy to virtually stall at somewhere between zero and 1 percent growth in 2007. He predicts the Fed will lower its benchmark short- term interest rate to 3.75 percent by the end of the year from 5.25 percent now.

A majority of traders anticipate that the Fed will cut rates next year, starting in the summer, though not by quite so much. According to the market for interest rates futures, the Fed is expected to lower its benchmark rate to 4.75 percent by the end of 2007.

Yet for all the economists taking their cue from Palau's bleak outlook, others look to McCarthy's booming business.

Bruce Kasman, chief economist at J.P. Morgan, forecasts the economy will grow a healthy 3 percent in 2007. Rather than cutting interest rates, the Fed may well have to raise them again to quell inflationary pressures, he said. "The rates market is pricing in weak growth and Fed easing," Kasman said. "If our view is right, there will be a correction."

Economists were taken by surprise by the speed at which the housing market changed from a surging bubble to a sinking stone. Today, there are some signs that the worst has passed: mortgage applications seem to be bottoming out, for instance.

But the number of permits issued to build new houses fell for the 10th straight month in November, and they are down about a third since November of last year. Residential investment plummeted in the second and third quarters of this year.

Employment in construction has fallen; so has the production of construction materials and other items related to housing. In the third quarter, the slowdown in home building subtracted more than a full percentage point from economic growth.

But for all the damage done by the deflating housing balloon, it has so far been narrowly circumscribed.

Today, virtually every economist agrees that the housing recession is likely to continue weighing on economic growth. But the consensus breaks up over how bad that damage will be.

The biggest disagreement is over how intensely the housing recession will ricochet through the rest of the economy and how it will affect consumer spending, which accounts for more than 70 percent of U.S. economic activity.

"I find it very hard to believe that what started in housing ends in housing," said Jan Hatzius, chief U.S. economist at Goldman Sachs, "that you are not going to get any spillovers from a major recession in a sector that accounts for 6 percent of the economy."

U.S. holiday sales rise 3%

U.S. holiday retail sales rose 3 percent from 2005 as a slowing housing market and higher energy costs cut into spending, Bloomberg News reported Tuesday from New York, citing a report from MasterCard Advisors.

The gain was less than the 5.2 percent increase in 2005 and the smallest growth since the survey started in 2003, MasterCard Advisors said. Electronics and luxury goods had the strongest sales, according to a company survey.

Holiday sales slowed this year because of higher interest rates and gasoline and heating fuel prices, said Michael McNamara, vice president for research at MasterCard Advisors. Warmer than normal weather in some regions of the United States hurt apparel sales, he said