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Economic Forecasts

Mild Recovery Faces Test Ahead

The economy's picking itself up, but there are forces trying to knock it down.

For the next few months, the economy is likely to feel fairly good. After four straight quarters of contraction, third quarter growth pegged at an annual rate of 3.5% will buoy the spirits of consumers and business managers, raising hopes that layoffs are over and net job gains are imminent. Joel Prakken, chairman of Macroeconomic Advisers, says the U.S. has escaped what could have been another Great Depression.

But by early spring: A test of the recovery as well as of the credit system, 18 months after it teetered on the edge of collapse. Not to mention another trial of the Federal Reserve’s skill, as officials try to keep nurturing the credit market with low interest rates, without providing so much monetary slack for so long that a new financial bubble develops.

Several upward forces are at work. First, there’s the federal stimulus of $787 billion. It will continue to prime the pump, adding about $90 billion a quarter to GDP next year and creating jobs that will help lift consumer confidence.

Second, inventories will need more replenishing. Over the past five quarters, businesses cut back production and sold off inventory to meet recession-reduced demand. Now, available supplies have gotten too low and there’s evidence that factories are starting to hum again. Industrial production has posted three straight months of solid gains.


Exports should also tick higher in the coming year, as overseas economies start to pick up a little steam. The soft dollar will also help, making U.S. goods, including heavy machinery and technology equipment, more attractive to foreign buyers.

Fourth, low interest rates remain a key support, not only encouraging would-be home buyers to take the plunge, but also spurring companies to sell bonds, raising money for investment in plants and equipment. Odds are slim that Fed policymakers will hike rates before the middle of next year.

Finally, the recent pickup in housing construction should continue into 2010 and even enjoy a bit of a seasonal increase come spring. In addition to the attractive interest rates, a likely extension of the first time buyers’ tax credit -- and possibly an expansion of the credit to long-time homeowners who opt to buy a new abode -- will help buoy new-home starts.

Unfortunately, there are also some powerful downward pressures at play. Commercial real estate values continue to plummet. On a national average basis, property values have dropped about 35% over the past two years and are still falling.


Credit markets remain far from normal. A revival of securitization, which saw expansion of lending backed by mortgages on homes, offices and shopping centers, is still in the distant future. At the same time, banks remain leery of lending to small firms, especially those tied to housing.

The unemployment rate is headed to double digits by early next year and is likely to remain above 9% through 2010. Rehiring of the 7 million workers who lost their jobs during the recession will be slow, and the paychecks for many who find employment will be smaller than they had been. Says John Silvia, chief economist with Wells Fargo Securities, “People think they’ll get their old jobs back. It ain’t gonna happen.”

And the outlook for mortgage defaults and foreclosures is deteriorating. That’s sure to push average home prices even lower -- probably by an additional 10% or so before leveling off at midyear. And it may do even more damage, causing a steeper price slide that snuffs out the construction upturn and slams the brakes on consumer spending. What happens is critical, says Desmond Lachman, a fellow at the American Enterprise Institute: “Housing and the economy are joined at the hip.”

The competing pressures mean the recovery will be slow, but it’s unlikely that the pace of GDP would slip back into negative territory. For a while, the relief at seeing the tail end of the recession will act as a tonic. When that wears off, the patient will still be weak.

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