Will interest rate cut be enough to prop up the economy?

WASHINGTON -- The Federal Reserve's quarter-point interest rate cut Tuesday was aimed at preventing a recession that would end the economy's six-year expansion. But in the minds of some, the Fed is fighting a losing battle.

Headwinds are facing the economy: a continued slump in the housing market that is showing no signs of bottoming, elevated energy costs and tightening conditions in credit markets that threaten to make borrowing more difficult for businesses and consumers. And there are signs that consumers, the main engine for the U.S. economy, may be pulling back.

"A mild U.S. recession is now likely, with no growth for the year ahead," Morgan Stanley mschief U.S. economist Richard Berner said in a note to clients Monday.

Fed policymakers cut their target for short-term interest rates, which influence borrowing costs across the economy, by a quarter-percentage point to 4.25%. It was the third cut from the Fed in less than three months and brought the rate to its lowest since January 2006.

Still, some economists, such as Moody's Economy.com chief economist Mark Zandi, say the odds of a U.S. recession are above 50%. Merrill Lynch North American economist David Rosenberg predicts consumers next year will cut their spending for the first time since the downturn of 1991. That would lead the overall economy into recession, marked by rising unemployment and softening business investment.

Global Insight U.S. research director Nigel Gault says the economy is in the "danger zone," with no growth in the fourth quarter. A shock, such as a renewed surge in oil prices, would push the economy into recession, he says.

"We're back to a nervous climate," says Joseph Bushey, president of Atlanta-based POS World, which sells such tech equipment as bar-code readers, touch-screen monitors and receipt printers.

Profit margins have fallen, in part because of higher shipping costs. And he has had to be more stringent with credit after some of his clients have gone bankrupt or fallen behind on their bills. Wild swings in the stock markets are also giving him jitters, he says.

"I'm a little bit nervous about where we are going in the next couple of years," Bushey says. "Every time I hire somebody, I keep thinking that I hope this isn't somebody I'm going to have to lay off next year."

Counting on the Fed to help

There are also a number of strengths in the economy, such as low unemployment and healthy export growth. Perhaps most important, Fed Chairman Ben Bernanke and his colleagues have shown a willingness to do what is necessary to keep the economy and the credit markets on track.

That could be a key factor that may keep the economy from sliding into its first recession since 2001, says David Resler, chief economist at Nomura Securities International. Berner says Fed action will likely prevent a recession from becoming too deep or long. Indeed, Gault, Rosenberg and other economists expect a pickup in the economy in the second half of 2008.

A panel of 16 economists from the Securities Industry and Financial Markets Association (SIFMA) anticipated in a recent survey that the Fed will cut rates to 3.5% by mid-2008. They expect the economy to slow in 2008, but, in part because of the Fed, not contract. The economy has been "resilient" in recent years, withstanding a number of shocks, including the housing slump, without sinking, Resler says, and there's reason to believe that resilience hasn't gone away.

Still, "The risks of recession are non-trivial," Resler says, noting 90% of those on the SIFMA panel said there was a greater chance that they were being too optimistic about the economy than too pessimistic.

Other forecasts, including those from UCLA and the University of Michigan, predict a recession will be averted. Robert Keats, president of Keats, Connelly and Associates, a Phoenix-based wealth-management firm, says he expects sales to continue to expand in 2008 and plans to add employees.

"We're confident that the economy is going to do OK next year. Not as well as this year … (but) we don't expect any kind of hefty recession," he says.

In its post-meeting statement Tuesday, the Fed said the economy was "slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending." Fed officials also noted increased turmoil in financial markets.

The policymakers did not suggest which way they were leaning for future rate decisions.

"Recent developments, including the deterioration in financial market conditions, have increased the uncertainty surrounding the outlook for economic growth and inflation," they said.

Economy facing risks

The credit crunch and the turmoil in financial markets, which have spiraled from the subprime mortgage meltdown, are what worry many economists. Morgan Stanley's Berner said in his recession warning that "compared even with a few weeks ago, financial conditions have tightened significantly further as the price of credit has risen and lenders have made credit less available."

That could make it harder for businesses and consumers to borrow, leaving less money to spend in the economy. For example, JPMorgan Chase jpmsenior economist James Glassman says it's possible the credit conditions could lead to a drop in non-residential construction, which has been strong enough to help offset the drop in housing.

"Finance really does matter. … That's why we need good financial machinery, (and) there's more risk that we're not going to have it," OppenheimerFunds chief economist Jerry Webman says.

Other negatives facing the economy:

•Housing. The Mortgage Bankers Association last week said that nearly 20% of higher-cost subprime adjustable mortgages were past due in the third quarter. The number of prime mortgage loans in default is also climbing. New-home sales are down 24% from a year ago, while existing home sales are off 21%. Prices are declining at double-digit rates in some regions.

Wachovia economists Mark Vitner and Adam York predict all major national measures of home prices will fall in 2008, and forecast it will take years for new-home sales to return to recent levels.

•Energy. Although energy prices have dipped recently, costs are still higher than they were a year ago, a factor that is likely forcing some consumers and firms to cut their spending in other parts of the economy.

The nationwide average price for a gallon of regular gasoline dipped below $3 Tuesday, down more than 10 cents from a month ago, but still 70 cents higher than a year ago, according to motorist group AAA. Oil prices are hovering around $90 a barrel after coming within cents of the $100 mark last month. Oil prices were just above $60 this time a year ago.

•Consumers. Consumers are feeling the weight of the negative news. The consumer confidence index was 87.3 in November, down from 95.2 in October and the lowest since October 2005, following Hurricanes Katrina and Rita, the Conference Board said.

Retail sales rose 0.2% in October, the period of latest government data, the smallest rise since August.

JPMorgan Chase's Glassman says the "remarkable period" of consumer spending, fueled by tax cuts, a strong housing market, healthy economic growth and booming stock prices, has likely come to an end.

•Businesses. Tuesday, the National Federation of Independent Business said its index of optimism among small-business owners was 94.4 in November, down 1.8 points from October and lowest since 1993.

Earnings fell 9.5% in the third quarter from a year earlier and are expected to drop 1.6% in the fourth quarter, according to Standard & Poor's. Earnings growth is expected to return in 2008, with double-digit gains anticipated in the second half of the year.

Exports a bright spot

Not all the news is bad.

Aided by a weakening dollar, exports have been rising at a rapid clip, providing a boost to the U.S. economy. Sales of U.S. goods abroad soared at the fastest pace in nearly four years in the third quarter.

"Trade continues to stand out as one of the few bright spots in an otherwise cloudy U.S. outlook," Lehman Bros. economists Ethan Harris and Zach Pandl said recently, predicting the gains will continue given the dollar's drop and strong growth abroad.

But that assumes U.S. trading partners will not be dragged down by the slowing in the world's largest economy. Morgan Stanley's Berner and other economists say such contagion is already hitting, leading to expectations for a slowing world economy.

The job market, meanwhile, has slowed, but it is showing no signs of collapse. Companies added a seasonally adjusted 94,000 workers in November following an increase of 170,000 in October, the Labor Department said. The unemployment rate was 4.7% for a third-consecutive month, up from the recent low of 4.4% in March. Wages were also up last month.

Edward Leamer, director of the UCLA Anderson Forecast, points to the job market as the reason why a recession isn't a certainty. Past downturns have been preceded by large increases in employment. When the economy softens, those workers are cut.

But this time, job growth has been slow, suggesting there is little fat to trim from company payrolls. That means it's highly unlikely companies will cut the 2 million workers Leamer estimated last week would be needed for the economy to sink into a recession.

"Be calm, my friends. Be calm," Leamer wrote.

Contributing: Sue Kirchhoff and Matt Krantz