Economy: Inflation may not be the biggest risk

WASHINGTON -- Markets have the shakes. The housing sector is searching for a bottom. Consumers look fatigued. Oil prices are volatile.

Is an economic soft landing supposed to feel this rough?

The Federal Reserve meets today to discuss interest rate policy, bolstered by data pointing to the slower, sustainable growth and gradually moderating inflation it has predicted. But Fed Chairman Ben Bernanke and his colleagues also face turmoil in stock and bond markets, despite Monday's stock rally, as traders worry that an economic expansion built largely on easy credit is too brittle to hold together.

In the near term, Fed officials have given no hint of budging from their current policy of keeping interest rates steady as they focus on tamping down inflation. The central bank has held a key short-term rate at 5.25% for more than a year.

The question is what happens to the economy and Fed policy later this year and into 2008. Economists, including those at the Fed, have been reducing their growth estimates. While many expect the nation to avoid a sharp downturn, given the strong world economy, tight labor market and healthy corporate profits, the shaky financial markets have added a new layer of risk.

Nariman Behravesh, chief economist at Global Insight, says the economy appears to be in a soft landing, predicting a slow 2% to 2.5% annual growth rate ahead. He adds, however, that the economy's "deceleration does make us vulnerable to another shock."

Spreading credit crunch

The big, emerging area of worry is the financial markets, where interest rates on some corporate debt have jumped in recent weeks. Soaring defaults in subprime mortgages, which are higher-priced loans to consumers who have impaired credit, have forced dozens of lenders out of business and torpedoed investors who bought bonds backed by the loans. That, in turn, has prompted even lenders of higher-quality mortgages to tighten terms or stop offering some products, which could further delay a housing recovery and cut overall growth.

Martha Pomerantz, principal and co-chair of the investment committee at Lowry Hill, a $7 billion high-end individual money management firm, says the strong global economy means companies will continue to find markets and financing and to post healthy profits.

Financing for corporate deals has been historically cheap and is now simply moving to more normal levels, she says. There's a "movement of money from riskier markets to higher-quality companies that … have good prospects for durable earnings growth," Pomerantz says.

Others are less sure, saying the bills are coming due for a cheap credit binge that resulted in too many houses no one wants to buy and a slew of questionable business deals.

"Slowly but surely, investors are opening their eyes to the reality of the widespread credit excesses of the past and tightening the noose around the neck of future credit availability," investment advisory firm Caldwell & Orkin said in a recent analysis.

The economy has generally unfolded as the Fed has predicted in the past year and a half, though the central bank last month reduced its growth forecast, calling the housing correction worse than expected.

Signs of strength

Unemployment is a low 4.6%. An index of core inflation, a measure that doesn't include volatile food and energy prices, has declined from 2.5% in November to a 1.9% rate in the 12 months ended in June, near the top of the Fed's informal comfort zone.

U.S. exports have picked up, manufacturing has expanded and the strong commercial real estate sector has helped dull the losses from the housing plunge. World economic growth is booming.

"If it is a financial crisis, it's a great time to have one," says Jim Paulsen, chief investment officer of Wells Capital Management, who says the markets have overreacted. "We've got the business sector coming back; clearly, international trade is coming back, and so is manufacturing."

The Fed has given no sign that it plans to change interest rate policy in the near term due to stock and bond market gyrations. Fed Governor Randall Kroszner told the Senate Banking Committee on Thursday that economic fundamentals hadn't changed since mid-July, when the Fed released its outlook and called inflation its predominant concern.

Still, forecasters at financial firms such as JPMorgan jpm that had predicted the Fed would raise rates this year to attack inflation, are now backing off those forecasts and focusing more on slower growth. Futures markets contracts that predict Fed policy are giving higher odds of a rate cut later this year.

Mark Zandi of Moody's Economy.com says the Fed could change the wording of its statement to indicate that inflation is no longer its main risk and cut rates later this year to help get the credit markets moving again.

"It's a rational repricing of risk, but when markets are repricing like this, they are extra vulnerable," Zandi says. "If anything goes wrong … you'll get a credit crunch."

A drag from housing

New-home sales are down 20% from last year, and Bernanke warned that housing will be a drag on the economy into next year, even if things start to turn around, given the large inventory of unsold homes to be worked through. Some builders think the pain could last longer than that.

"None of the large public (builders) are buying any land, there are more lots for sale and more land that's sitting," says Marsha Elliott, president of Terrestris Development in Chicago, a midsize home developer.

Elliott, who has been in business for three decades, calls this downturn the strangest she's seen in the sense that it's not pushed by fundamentals such as rising interest rates or a bad job market. She doesn't expect recovery for, "a couple of more years, at least. It's 'batten down the hatches.' "

Doug Duncan, chief economist of the Mortgage Bankers Association, says the problem isn't the cost of credit, but the availability of buyers in the secondary market for mortgage-backed securities due to perceived risk. Interest rates on high-quality mortgages have actually dropped in recent days, with some rates near 6.5%.

He expects the Fed to stand back a bit to gauge where housing is going, adding that a hasty rate move could be misinterpreted by markets. He now expects it will be "well out into 2008" before the housing fall hits bottom.

Andrew Chaban, CEO of Princeton Properties in Lowell, Mass., which owns and manages about 5,500 apartment units, says the real estate market in areas of the Northeast where he operates is holding its own — for careful projects.

"If you have taken more gambles … if you've overleveraged your property, you don't have enough equity in the deal, those are the types of deals we see being hurt," Chaban says.

While Bernanke's housing outlook is hardly upbeat, some analysts think he's far too optimistic. In particular, they dispute the Fed's analysis that problems in the housing sector haven't spilled into other areas of the economy — especially after the recent market churning from subprime — and that the falloff in housing will have only a small impact on consumer spending.

"The wealth effect (from rising home prices) equity extraction and excessive home building were absolutely necessary for this expansion to continue as long as it has or even continue at all," says Kevin Feltes, director of the Jerome Levy Forecasting Center.

Feltes predicts a broad retrenchment in consumer spending in the longer term, with borrowing and spending falling more than at any time since the early 1980s.

Economist Richard DeKaser of National City Bank, by contrast, says that even a sharp cutback in home equity withdrawals will have only a minimal impact on growth.

Benjamin Holzer, 36, of Queen Creek, Ariz., near Phoenix, says he's in pretty good shape, despite housing market troubles.

"I live in the most expensive house that I can afford," Holzer says, adding that the value of his home has risen so much since he bought it that anything short of a dramatic drop in real estate prices won't sting. "At the very worst, the market will come back down to a more normal situation. I'm in a good spot."

Consumer spending, two-thirds of the economy, held the recovery together in the early part of the year, but gains slumped this spring. Consumer confidence rose in July, but USA TODAY polls find a majority of respondents expect conditions to get worse.

"Things are getting more and more expensive; fuel is way up there. I've honestly had to stop working because my income wasn't helping. I was having to pay day care and extra gas; I was paying almost an extra $150 on gas a month," says Christina Howard, 32, of Port St. Lucie, Fla.

Economists have been counting on steady wage growth and a tight labor market to blunt some of the impacts of higher gasoline prices and the housing market slump. Job growth was below predictions in July, though the unemployment rate remains low at 4.6%.

"What we're seeing is that feeling you get when you're going to the dentist. … There's a lot of anxiety under the surface," says Phil Rist of BIGresearch, a consumer research firm.

Nervous about oil prices

Core inflation — minus food and energy prices — is declining at the same time as the inflation measure that includes all prices is under pressure. Oil prices hit a record high (not adjusted for inflation) of $78 a barrel last week, though they declined sharply Monday to a still-high $72.06 a barrel for light, sweet crude oil trading for delivery in September. The Fed focuses on core prices because they give a better sense of underlying inflation pressures. But that doesn't mean the central bank doesn't pay attention to the overall inflation number.

"We drive; we eat; we understand that inflation involves all prices, not just those that are not volatile," Bernanke told Congress.

A big risk is that higher energy prices will start to work their way through to consumers, pushing inflation as they slow the economy.

Cliff Waldman, economist at Manufacturers Alliance/MAPI, a trade group in Arlington, Va., says so far, manufacturers are able to weather the high energy costs, but their tolerance is "not limitless."

A strong worldwide economy is leading to stronger export growth, and improved technology has allowed factories to use less energy in their production processes, both factors that are aiding factories. But if prices were to go higher and stay there, it could cause problems for the economy, he says.

"As oil climbs, we have a reason to get a little nervous," he says.

Contributing: Barbara Hagenbaugh