Can the Economy Keep up the Pace?

It still has some underlying momentum. But the growing list of risk factors is worrisome.

By Jerome Idaszak, Associate Editor, The Kiplinger Letter

Peter Goldstein, Senior Economics Editor, The Kiplinger Letter

August 7, 2007

Bearish equities markets have people worrying about the economy.

Do slumping stocks foretell a recession ahead? We still say no, given the support the economy continues to draw from employment, exports and other factors. These should be enough to sustain an expansion, albeit at a sluggish pace, in coming months as well as in 2008.

Officials at the Federal Reserve seem to agree. Keeping interest rates unchanged at their Aug. 7 meeting, members of the central bank's Federal Open Market Committee did take note of recent turmoil in financial markets and tighter credit conditions. But they also stressed that "the economy seems likely to continue to expand at a moderate pace over the coming quarters." This doesn't sound like a Fed that's ready to cut rates.

Even so, the growing menu of risks to growth can't be ignored. In housing, the accelerating retreat of financial backers from the mortgage and home building industries is worrisome. The danger here is that building, a key element in the calculation of gross domestic product, will simply tumble off a cliff rather than continue its gradual bottoming out.

In energy, the rise of the price of oil to near $80 a barrel comes at a very bad time -- just as the peak of the Gulf Coast hurricane season threatens the area's extensive oil and refinery installations. A direct hurricane hit in the oil patch could easily push oil to $100 a barrel. In any event, gasoline's late-summer price decline probably won't last much longer. Earlier this year, refiners built inventories of cheaper oil that they're still using. But these supplies will run low in a few weeks, forcing refiners to rely more on currently pricey crude.

In the stock market, a sustained drop could strike a big blow to consumer and business confidence. Consumers already are pulling back on spending, judging from the most recent auto and retail sales figures. We don't think the market will fall out of bed, but an ongoing stream of bad news about the housing sector plus tighter credit markets and high energy prices may well continue to weigh on investor sentiment.

One sure thing: The economy's boost from export growth isn't in jeopardy. If anything, the global economy is likely to be stronger than expected for the balance of this year, as countries in Asia, Europe, the Middle East and Latin America all post healthy rates of expansion, fueling demand for U.S. products.

Employment also will remain a plus. Firms are continuing to hire, though at a slightly slower pace than they were a few months ago. We expect monthly job gains to average a decent 110,000 through the end of the year.

Of course, a potential problem is a credit crunch that cuts off business investment, which would likely lead to companies scaling back their hiring plans. This would probably be the last straw for American consumers, who are struggling with less asset appreciation and high prices. So far, however, the financing pinch on companies doesn't seem too bad overall. Loads of firms continue to enjoy healthy balance sheets, giving them solid negotiating power with banks when it comes time to get a loan. Creditworthy companies also can still arrange debt financing, albeit at a somewhat higher cost than a few months ago. The interest rate spread between corporate bonds and Treasury yields has been widening in recent weeks, but Treasury yields have also been falling, offsetting the spread expansion.

If growth truly does dry up, expect the Federal Reserve to open a spigot, lowering interest rates and thereby making credit more readily available.

But the central bank isn't going to make any preemptive moves, preferring instead to see solid evidence of a coming slump. Why? Ongoing inflation pressures from rising wages and high commodity prices preclude Fed Chairman Ben Bernanke and his colleagues from taking any chances.

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