Economy's recovery caught between opposing forces

— -- Economists may have finally learned CEOs' first rule of dealing with Wall Street: It's better to underpromise and overdeliver.

For the past two years, forecasters have overpromised, as bullish predictions for 2010 and 2011 fell short. Last year's hoped-for recovery soon faded in the fallout from Japan's earthquake, coupled with Washington's flirtation with defaulting on the national debt.

Heading into this year, economists all but unanimously predicted a first-half slowdown that would keep unemployment near 8.5% through the election.

Fortunately, so far this year they've been wrong again.

Fed Chairman Ben Bernanke will discuss the Fed's outlook today after the Fed's policymaking body ends its two-day meeting. On Friday, the government is preparing to report first-quarter growth, which is expected to beat most economists' estimates from three months ago — maybe as high as 3%, says Diane Swonk of Mesirow Financial, who had predicted only 1.9%. Joblessness is at 8.2%, and USA TODAY's 50-member panel of economists forecasts it will reach 8% by year's end.

As the recovery finally puts down what appear to be stronger roots, it faces one big force that could strengthen and reinforce it — and an even bigger one that threatens to derail it.

Coming down the track from one direction is the bullish force of pent-up demand — especially the potential buying power of households that haven't been formed since 2008 as the recession and its aftermath forced young people to double up, not move out of relatives' homes or not get married.

In the other direction is another Washington-induced showdown: a locomotive of expiring tax cuts and spending reductions set to take effect Dec. 31 that forecasters think could shave 3.5% off the economy next year — in essence, negating all of its 2012 growth and then some — if the election doesn't produce a clear direction for fiscal policy.

"People don't realize the U.S. was the only major economy in the world that improved last year," said Richard Bernstein, head of money manager Richard Bernstein Advisors in New York. "It's not strong, but it certainly has improved. … As we progress through this year, the fiscal cliff will be a major issue — for (financial) markets all over the world."

Running off that fiscal cliff would add more pain to what has been the most painful recession and protracted recovery in most Americans' lifetimes. The 2.5% growth economists predict for this year is nothing special but better than last year's 1.7%. The economy grew 7.2% in 1984, coming out of the next-deepest postwar downturn.

Deep wounds, long recovery

The recession was deep, and the recovery long, for the same reason, Fed Governor Sarah Raskin said in an April 12 speech. Americans got in over their heads on housing, then saw $7 trillion of home equity and 8.8 million jobs wiped out by the housing bust and its aftermath. Consumers have also been slow to resume spending because they have so much debt left over from the housing bubble, said Carmen Reinhart, co-author of This Time Is Different, a 2009 book that argues recoveries from downturns caused by financial panics are always protracted.

While consumers' debt payments have come down because of lower interest rates, their debt loads are twice as large as after the 1982 recession, Reinhart said. The result: Even with 4.1 million new private-sector jobs added since February 2010, the U.S. is still 5.2 million total jobs below January 2008.

But that effect is slowly wearing off. With a boost from rapid retirements among Baby Boomers, the unemployment rate has dropped nearly 2 percentage points in two years. Two different surveys Tuesday reported modest gains in housing prices, and first-quarter new home sales were up more than 10%, helped by better credit quality among more-recent mortgages and a slow unwinding of the stock of foreclosed homes.

"Growth is 2.5%, rock-solid," said Mark Zandi, Moody's Analytics' chief economist, reflecting the consensus of USA TODAY's panel of economists, whose median 2012 growth estimate is 2.5%.

"Job growth is 175,000-200,000 a month, pretty much rock-solid. We were at 250,000 a month, but some of that was the warm winter, and March (when the economy added 120,000 jobs) was a kind of payback," Zandi said.

The Federal Reserve is still worried enough to keep monetary policy very loose. It has committed to keeping interest rates "extremely low" through late 2014, even though more than 80% of USA TODAY's economists now expect the Fed to raise rates sooner.

Wall Street is also campaigning for the Fed to do more bond-buying operations, known as quantitative easing, in which the central bank pumps money into the economy by buying U.S. Treasuries and other government-backed bonds. Some on Wall Street, including Goldman Sachs Asset Management Chairman Jim O'Neill, have worried that the recent uptick in new claims for unemployment insurance may herald a new slowdown in growth.

"The last two weeks have not been great for those thinking of GDP growth surprising significantly" for the better, O'Neill wrote on Monday. "We need to take each stage of evidence as it comes."

Many of the forces that have prompted recent worries are fading, however:

•The eurozone's financial woes are a long way from over, but the crisis has calmed some since the European Central Bank created a 500 billion euro ($658 billion) lending program to prop up continental banks in December.

•The increase in the price of gasoline that sparked renewed recession fears in the U.S. this winter is abating. Gas prices have fallen 7 cents a gallon in the last two weeks, to $3.87 a gallon for regular, and are now slightly below this time last year, the Energy Department said.

•Consumers' debt payments as a percentage of their income are at their lowest levels since 1994, according to the Fed.

That sets the stage for consumer confidence, and especially new household formation, to take the recovery up a notch by next year, Zandi argues. Household formation fell to 357,000 in the year ended in March 2010, where 1.2 million is normal, he said. He estimates the car market has 2 million units in pent-up demand.

"You have a lot of twentysomethings who have been doubled up with their parents because they couldn't find a job," Zandi said. Coupled with people who have put off buying cars or houses because of the economy, household formations should help push up vehicle demand by another million units a year, to 15.5 million, he said. At the same time, home building could double from last year's record low as the market works off the backlog of foreclosed and vacant homes. Both should be underway by late 2013 or 2014, he said.

Car sales have already picked up. Washington, D.C.-area dealer Darcars Automotive Group posted a 14% sales gain in the first quarter, Vice President Tammy Darvish said.

"We're back to worrying about growing our facilities," said Darvish, whose $100-million-a-year company has more than $10 million in capital improvements underway. "A lot of it has to do with the age of cars on the road, and the biggest accelerant has been better availability of credit."

Headed for a cliff?

The big question is whether the other train coming down the track is even more powerful — and what Washington should do about it.

Two major economics consulting firms, Moody's and IHS Global Insight, have said the nation could lose substantially all of its short-term economic momentum after the election if potential tax increases and budget cuts go into effect simultaneously.

Each put the potential impact of allowing the 2001 and 2003 Bush tax cuts to expire, sunsetting the 2010 payroll tax cut that was extended to last through this year, and letting $900 billion in automatic spending cuts over 10 years take effect as scheduled, at 3.5% of gross domestic product. That's worth about $550 billion, based on last year's GDP of $15.1 trillion.

Neither party so far has proposed anything as drastic as rushing headlong off what Bernanke has called the "massive fiscal cliff" waiting at the end of the year. President Obama has proposed raising taxes on incomes above $250,000 for couples and $200,000 for single taxpayers. Mitt Romney, the likely Republican presidential nominee, has proposed a 20% income tax cut across the board. Both have proposed cutting corporate tax rates.

But unless Congress can forge a deal by Dec. 31, all the tax cuts will expire and spending reductions will take effect in January. That has economists on the left and right musing about alternatives.

Congress could cut the deficit and protect the economy by phasing out Bush's tax cuts for the top two brackets, covering joint filers with incomes above $212,300, instead of just the top bracket, said Jared Bernstein, a former top aide to Vice President Biden who works at the Center on Budget and Policy Priorities in Washington.

He would also phase out tax cuts for middle-income consumers as the economy improves, until most people pay the tax rates they did under President Clinton. Bernstein would suspend most of last summer's spending cuts in exchange for phasing out extended unemployment benefits and the payroll tax cut as unemployment falls.

A small number of GOP-leaning economists are also calling for the party to compromise some, and to tone down their rhetoric on the economy.

"A lot of conservatives have been way too negative on the economy," said Brian Wesbury, chief economist at asset manager First Trust in Chicago, and a former chief economist for the congressional Joint Economic Committee.

The likeliest outcome is for the post-election Congress to split the difference, extending some tax cuts and not following through immediately on all the planned spending cuts, Zandi said.

That strategy could produce 3% growth next year and 4% in 2014, he said. Unemployment might fall to about 7% by the end of 2013, he added — the lowest since November 2008.

But until Congress and the president make a deal, economists and market analysts don't rule out another drama like last year's debt-ceiling showdown, which helped stall the economy and slice 20% off the stock market.