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US economy – waiting for the other shoe to drop

With forces building up, some economists expect a verdict soon

(NEW YORK) For months, the American economy has been assailed by a wave of troubling news, from plunging housing prices to the soaring cost of oil, provoking gloomy talk of a possible recession. Yet so far the economy has found a way to shrug it all off and keep growing.

How much longer can the expansion carry on? As a new year unfolds, analysts expect a verdict soon: Either the negatives finally metastasise and drag the economy down, or a fresh source of growth emerges, helping to sustain consumer spending despite the ongoing worries about housing and tight credit.

‘There are even odds of a recession,’ said Mark Zandi, chief economist at Moody’s Economy.com. ‘It literally could go either way.’ The year that just ended was not for the faint of heart. As mortgage debt became synonymous with toxic waste, banks got spooked and tightfisted. Job growth slowed. Inflation fears grew. Still, consumers kept spending, and unemployment stayed flat. American companies found enough sales abroad to compensate for weakness at home.

The bursting housing bubble remains a focus of concern. An era of free-flowing credit and speculation has led to a far-flung empire of vacant, unsold homes – 2.1 million, or about 2.6 per cent of the nation’s housing stock, Mr Zandi said. Even in the worst years of recessions in the early 1980s and 1990s, the share of vacant homes did not exceed 1.9 per cent.

This assemblage of unsold properties will not be whittled down to normal levels, economists suggest, until national home prices fall by at least 15 per cent from their peak, reached in the summer of 2006. So far, prices have dropped a little more than 5 per cent, according to the Standard & Poor’s Case-Shiller home price index.

The glut could be exacerbated if an already alarming wave of foreclosures continues to broaden, claiming even those with supposedly good credit.

Last year, the trouble in the mortgage market was largely confined to sub-prime loans extended to homeowners with weak credit. Nearly one-fourth of such loans were in default as of November, according to data from First American LoanPerformance and the Federal Reserve Bank of New York.

Though default rates on loans to homeowners with relatively good credit are far lower, they are rising sharply, too.

In November, 6.6 per cent of so-called Alt-A home loans – those deemed somewhat less risky than sub-prime – were either delinquent by 60 days or more, in foreclosure, or had been repossessed. That was up from 4.3 per cent in August.

This is a potentially ominous sign, because sub-prime and Alt-A mortgages issued in 2006 together made up about 40 per cent of all mortgages. Like many of the sub-prime loans that have landed in trouble, Alt-A loans often begin with a low introductory interest rate that then jumps.

The spike in foreclosures is happening even before many mortgages have reset to higher rates, suggesting that borrowers are falling behind because their homes are worth less. Many are having trouble refinancing as banks tighten lending standards.

All of which explains why many economists expect national housing prices to fall by 5 to 10 per cent more in 2008, and perhaps into 2009 as well, before hitting bottom.

Such a drop could ripple out to the broader economy by depressing consumer spending, which accounts for about 70 per cent of all economic activity.

‘It’s almost inconceivable that there won’t be severe constraints on the US consumer economy,’ said Bernard Connolly, chief global strategist at Banque AIG in London.

Forecasting the demise of consumer spending, however, is notoriously risky. The willingness of Americans to spend, whatever the size of their debts, seems to transcend the rules of economics.

But conditions suggesting a slowdown have been taking shape: The labour market cooled last year, creating new jobs at roughly half the rate of 2006. Wages grew slower than inflation during the last two months. Early indications suggest Americans were relatively thrifty during the holiday season.

‘You have to ask yourself: Where does the consumer continue to get his or her spending power?’ said Jared Bernstein, senior economist at the liberal Economic Policy Institute in Washington. ‘If consumption falters, it’s good night nurse for the American economy.’

 

Source: NYT (Business Times 3 Jan 08)

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