Is a Recession Ahead?

The economy faces big challenges, but a soft landing is still far more likely than a slump.

By Jerome Idaszak, Associate Editor, The Kiplinger Letter

July 26, 2006

The "R" word is creeping into talk about the economic outlook for the first time in a couple of years. Jitters about a recession are understandable, given the large number of wild cards in the economic deck: The possibility of supply disruptions in the already-tight oil market, uncertainty about the Federal Reserve's next move on interest rates and signs that the housing market is quickly losing steam. But a recession isn't likely. There are more than enough high cards in this economy to keep growth from folding, despite the apparent risks.

Granted, soft landings are always tough to engineer. Whenever the Fed embarks on a sustained course of rate increases—it has done so seven times since the early 1970s—the economy becomes more vulnerable to outside shocks. And more often than not, the Fed has overshot on rate hikes, triggering a swift economic retreat. But this time around, there's plenty of cushioning to prevent a hard fall.

Though consumer spending is taking a hit from surging energy prices and climbing short-term interest rates, employment growth will remain healthy enough through next year to underpin consumers' wallets and their confidence. Growth in personal income is likely to remain comfortably above the rate of inflation, making folks feel wealthier. Household balance sheets are in good shape, thanks mainly to the growth in the value of homes and stocks in recent years. Interest rates, while on the rise, remain low by historical standards, limiting the burden of debt payments.

On the business side, healthy sales and good cash flow will feed capital spending, albeit at a moderate pace. Economic growth abroad is generally strong, providing a nice lift for U.S. exports. Domestically, state and local governments are in better financial shape, allowing them to spend more on public works and services.

All in all, we expect economic growth to average about 3% in this current half and then downshift to a few ticks below 3% next year. As for interest rates, the Fed's next move on Aug. 8 will hinge on how much gross domestic product (GDP) growth slowed down in the second quarter, the strength of job gains in July and the path of oil prices. If the GDP figure, due out July 28, is above 3%, employment increases by at least 150,000 in July and oil prices remain above $75 a barrel through the August Fed meeting, another quarter-point hike is a lock. If none of that happens, the Fed will stand pat. Of course, the odds are that the data will fall in the gray zone, making a decision difficult.

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