An Economy of Extremes (NYTimes, 12/26/06)

December 26, 2006
An Economy of Extremes
By EDUARDO PORTER
Economists have long waxed lyrical about a “Goldilocks economy”— one that is not too hot, not too cold.

In this ideal world, the economy is running so smoothly that there is little risk of it overheating and pushing inflation higher — forcing the Federal Reserve to raise interest rates. Nor is the job market weakening, threatening to plunge the economy into the icy bath of a recession.

The “just right” economy is not often achieved, of course, but lately this bedtime story has taken a particularly tricky turn: it is both too hot and too cold.

The housing market has fallen into a deep freeze; so has the auto industry. Yet on several other fronts, including commercial construction and high-end consumer spending, economic activity appears to be sizzling.

Lombard Street Research, a British economic forecasting firm, recently dubbed the American economy the “anti-Goldilocks economy.”

That is making it challenging for both economists and the Federal Reserve to decide which risk is greater: that housing will drag down the rest of the economy, pushing the Fed to cut rates, or that inflation will remain above the Fed’s comfort zone, forcing it to push up rates instead.

But others say that next year hot and cold could end up canceling each other out, turning the economy balmy.

For now, though, with home construction entering its second year of a downturn, many economists have aggressively pared back their forecasts for growth in 2007. Some have started to utter the R-word.

“We’ve increased the probability of a recession in our forecast to 35 percent,” said David W. Berson, chief economist of Fannie Mae.

On the other hand, Charles Dumas, who follows the American economy for Lombard from London, ticked off a list of countervailing forces from high employment and income growth to robust business investment.

“None of that speaks of a slowdown,” he said. “There has to be a landing but I don’t see any signs of it yet.”

The economy looks very different depending on whether you are inside or outside the housing market.

Consider Andrew Palau, who runs Premier Homes and Additions of River Edge, N.J. Business has dried up as the collapse of the housing market has slashed demand for new master bathrooms and refurbished kitchens across Bergen County in the northeast corner of the state.

“Homeowners don’t have a clear view in front of them so they are not investing because they want to hold on to the money,” Mr. Palau said.

He managed to hold on to his staff of 10 this year, but thinks he is probably going to have to let people go next year. “Everything is telling me that next year will be worse,” he said. “I don’t see how I can keep everyone.”

Virtually every homebuilder in the nation shares Mr. Palau’s concern. Yet a look just outside the border of the housing-linked economy provides a starkly different view.

“Our market is as close to capacity as you can get,” said Michael D. Bolen, chairman and chief executive of McCarthy Building Companies in St. Louis, a commercial builder of everything from schools and hospitals to casinos and parking lots.

To hear Mr. Bolen speak, the job market has the go-go feel of the Internet-driven boom of the late 1990s. “It’s as goofy as it’s ever been,” he said. “We’re offering signing bonuses and guaranteed locations to people coming straight out of school.”

Mr. Bolen said that McCarthy expected to increase its 1800-strong hourly work force by 10 to 15 percent when the construction season picked up in the spring.

This off-kilter performance has allowed for an unusually wide difference of views on the economic outlook next year.

Ian Shepherdson, chief economist at High Frequency Economics in Valhalla, N.Y., expects the economy to virtually stall at somewhere between flat to 1 percent growth in 2007. He thinks the Fed will slash its benchmark short-term interest rate from 5.25 percent today to 3.75 percent by the end of next year.

A majority of traders now anticipate that the Fed will cut rates next year, starting in the summer, though not by quite so much. According to the market for interest rates futures, the Fed is expected to cut its benchmark rate to 4.75 percent by the end of 2007.

Yet for all the economists taking the cue from Mr. Palau’s bleak outlook, others look to McCarthy’s booming business.

Bruce Kasman, chief economist at J. P. Morgan, forecasts the economy will grow at a healthy 3 percent clip in 2007. Rather than cutting interest rates, the Fed may well have to raise them again to quell inflationary pressures. “The rates market is pricing in weak growth and Fed easing,” Mr. Kasman said. “If our view is right there will be a correction.”

Economists were taken by surprise by the speed at which the housing market morphed from a surging bubble to a sinking stone. Today, there are some signs that the worst has passed: mortgage applications seem to be bottoming out, for instance.

But the number of permits issued to build new houses fell for the 10th straight month in November, and they are down about a third since November of last year. Residential investment plummeted in the second and third quarters of the year.

Employment in construction has fallen; so has the production of construction materials and other items related to housing. In the third quarter, the slowdown in homebuilding subtracted more than one percentage point from economic growth.

But for all the damage done by the deflating housing balloon, it has so far been narrowly circumscribed.

Today, virtually every economist agrees that the housing recession is likely to continue weighing on economic growth. But the consensus breaks up over how bad that damage will be.

The most important disagreement is over how intensely the housing recession will ricochet through the rest of the economy and how it will affect consumer spending, which accounts for more than 70 percent of the nation’s economic activity.

“I find it very hard to believe that what started in housing ends in housing,” said Jan Hatzius, chief United States economist at Goldman Sachs. “That you are not going to get any spillovers from a major recession in a sector that accounts for 6 percent of the economy.”

Many economists argue that the decline in housing prices experienced so far must inevitably deliver a big blow to consumer spending. Bluntly put, Americans who spent more than they earned as the price of homes soared cannot possibly go on spending as avidly now that the value of homes is tumbling. And if consumers spend less, businesses will stop investing.

Homeowners are certainly extracting less money from their homes to spend. Mortgage equity withdrawals, net of commissions and taxes, fell in the third quarter for the fourth time in a row, to about $380 billion at an annual rate, the lowest level in almost three years.

They are likely to keep falling. According to the Fed, the equity Americans hold in their homes grew only 0.1 percent in the third quarter, before seasonal adjustments. This was the slowest pace of growth in more than 10 years.

But for all this, consumers have not yet shown any sign that they are ready to put the wallet away. Overall consumer spending grew by 0.5 percent in both October and November, after accounting for inflation, bolstered by the decline in the price of gas.

Shawn DuBravac, staff economist at the Consumer Electronics Association, said he expected sales of everything from big screen televisions to digital cameras to grow by a little less than 7 percent next year, down from about 11 percent in 2006.

While profit margins among some electronics retailers are down due to intense competition, the business is holding up much better than expected. “Lots of people said the housing market would kill the economy,” Mr. DuBravac said. “That hasn’t happened. The consumer seems really healthy going into 2007.”

From hospitals to hotels, spending on services is growing. “This year has been a better year than last year,” said Anne Trevett, the innkeeper at Blackbeard’s Lodge in Ocracoke, a coastal island of North Carolina. “The only down times we have are due to bad weather.”

Even as the housing downturn has curtailed the ability of Americans to borrow, spending is being supported by jobs and wage growth. Employers are adding about 150,000 jobs each month, according to the government’s survey of businesses. As oil prices have declined, real wages have rebounded. Real disposable personal income has grown by 0.5 percent a month, on average, over the last three months.

Businesses are investing heavily, too. Nonresidential investment grew 10 percent in the third quarter, almost compensating for the 19 percent decline in nonresidential investment. “Outside of the housing and motor vehicle sectors,” said the Fed chairman, Ben S. Bernanke, in a speech late last month, “economic activity has, on balance, been expanding at a solid pace.”

There is one crucial weakness to all the forecasts, however. Part way through the bust of perhaps the strongest housing boom on record, the American economy is in uncharted territory.

Nobody has ever seen how a situation like this unwinds.

Allen Sinai, president and chief global economist at Decision Economics, observed that past housing-induced recessions were characterized by rising interest rates and tight credit, conditions that do not apply in these days of still cheap, easy money.

Some economists have drawn parallels to 2000 — when the Federal Reserve spun on a dime and started slashing interest rates only weeks after warning about inflationary risks. But the slump in 2000 came about because highly leveraged businesses, shocked by the end of the tech boom and the drying up of new orders, essentially stopped hiring and investing. Today, corporate balance sheets are in very good shape.

Still, there are enough uncertainties to warrant talk of a recession.

Mr. Sinai estimated that, over time, consumers ended up spending 40 cents out of every dollar in equity they extracted from their homes as house prices went up. They spent 28 percent of the capital gains they made when they sold their homes, and 3 percent of their increase in overall wealth.

“If housing is as unhelpful on the way down as it was helpful on the way up, we will get a recession,” Mr. Sinai said.

But at McCarthy, Mr. Bolen has other worries. “Our suppliers and vendors and subcontractors have been working so hard for so long they are going to get tired,” he said.