Economic outlook dims sharply

The US economic outlook is turning bleaker. Instead of asking whether there will be a slump, economists are now wondering how long and how deep the downturn will last.

According to some models, the economy has a rough first six months, probably contracting or showing almost no growth, then it recovers. More pessimistic economists see the downturn lasting longer, with the unemployment rate moving closer to 7 percent and growth constrained through 2009.

"Why is there so much uncertainty and angst?" asks Mark Zandi, chief economist at Moody's Economy.com. "It's because [the duration of the slump] depends on how deep and broad the problems in the credit market are. And right now, it's impossible to gauge because there is no good information."

Only a few months ago, Mr. Zandi thought there was at least a 50 percent chance the US economy would squeak through this year without a recession. Then the job market collapsed in December, holiday sales were disappointing, and the turmoil in the financial markets grew worse. Now, with economic conditions overseas weakening, he's more gloomy: "Economists all over are downgrading their forecasts and an increasing number have an outright recession forecast."

Those downgrades and forecasts are behind the rush by Congress to pass an economic stimulus package. They are one of the main reasons why the Federal Reserve decided on Tuesday to drop interest rates by three-quarters of a percentage point. And they are one of the reasons why the financial markets on Wednesday remained turbulent.

Even government economists admit the economic sands are shifting quickly. On Wednesday, the Congressional Budget Office projected the economy would grow by 1.7 percent in 2008. But CBO Director Peter Orszag also testified before Congress that "the state of the economy is particularly uncertain at the moment."

The optimists see the economy as rebounding somewhat in the second half. One of those is Bernard Baumohl, managing director of the Economic Outlook Group in Princeton, N.J., who says, "I believe we are in the initial phase of a recession."

But Mr. Baumohl believes the combination of interest-rate cuts and fiscal stimulus will set the groundwork for the economy to begin to come back in the second half. "I think we will see the beginning of a recovery, although it will be a soft one," he says.

As happens with all downturns, economists anticipate the unemployment rate will rise, probably throughout the year since business is often late in responding to changes in the economy. On Wednesday, Citigroup economist Steven Wieting cut his estimate for economic growth from 2.4 percent to 1.2 percent and projected unemployment would rise from its current level of 5 percent to 6 percent. This would imply a loss of about 2.5 million jobs.

Mr. Wieting currently expects the slump to be "mild but prolonged," not "quick and deep."

One of the reasons for a longer growth hiatus is that consumers will not be able to use their homes to get access to debt, says Michael Barron, CEO of Knott Capital, an investment advisory firm in Exton, Pa. "Consumers have been able to inflate their balance sheets with rising home prices."

On Tuesday, economist David Rosenberg of Merrill Lynch projected housing prices would fall 15 percent in 2008 and another 10 percent in 2009. In a draconian forecast, he sees housing starts falling another 30 percent to a low not seen since 1982. He says the decline will be necessary to clear record inventories.

With home prices flat or falling, it will be harder for consumers to buy boats, cars, and appliances, he argues. "There will be no pent-up demand, which normally helps lift us out of economic weakness," says Mr. Barron.

Barron also says the economy has changed because the banking system has tightened its lending standards. "Money is available, but the banks don't have to lend it," he says. "It is not that the demand is not there, but there is a higher scrutiny."

Baumohl says the key to recovery will be how fast the financial sector can strengthen its balance sheet. In recent weeks, financial institutions from Bank of America to Citigroup to Merrill Lynch have written off billions of dollars in loans.

"We have rarely had a recession where the financial sector is in such trouble," he says.

The problems in the financial sector are the main reason that economist Gregory Miller of SunTrust Banks in Atlanta says the economy won't recover until the first half of 2009. "We are in a situation where the interest rates are falling but they don't generate much activity," he says. "Banks are very reluctant to add new assets to their balance sheets when they are still uncertain about the value of the loans they have on their books already."