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Taking stock of a shaky economy

Everywhere you turn, the news on the economy seems dire. Oil prices are through the roof, home prices are through the floor, the stock market is plunging, and the entire U.S. economy seems shaky. Here's a look at what's going on, why and when we'll know things are turning around.

Q: What's hurting the U.S. economy now?

There are three big drags on our economy: the slumping housing market, the sustained rise in oil prices and an increasingly fragile banking system. Combined, they're socking it to the economy.

Q: When will housing stabilize and rebound?

The answer will determine when the economy rebounds.

Housing is shaving about 1 percentage point off national economic growth every quarter. Nationally, home prices in April were 15.3 percent lower than in April 2007, according to the S&P/Case-Shiller Index of 20 major metropolitan areas.

It varies by local market, but virtually all are down. Even Charlotte, one of the nation's hotter markets, saw a year-over-year drop in home prices.

Home prices shot up excessively from 2002 to 2006 and are correcting. The million-dollar question is whether they'll flatten out or keeping falling in a way that mirrors the steep run-up.

“I think there's some room to go (down) on this market,” said Cameron Findlay, chief economist for online mortgage lender LendingTree.com in Irvine, Calif.

Home prices are unlikely to bottom before next March, he said. Until then, “I think foreclosures are going to continue to drive those prices down, and that's driven primarily by the higher inventory of unsold homes.”

Q: How will we know when the worst is over?

When home sales start to pick up consistently in the hardest-hit markets, such as Florida and California. “House prices have to stop falling, or at least the rate of decline has to slow,” said Mark Zandi, chief economist for forecaster Moody's Economy.com.

Q: How do high oil prices affect today's economy?

Businesses spend more on oil and products derived from it, including plastics, packaging and transportation. Consumers spend more of their income on gasoline, leaving less for other purchases, from restaurant meals to TVs.

High oil prices boost inflation, the rise of prices across the economy. Businesses have resisted passing along all their rising energy costs to consumers, and oil's rise hasn't yet shown up in “core inflation,” the measure that strips out volatile energy and food prices to show deeper trends.

But the longer that oil stays high, the greater the chance of an inflationary spiral in which wages and prices chase each other upward.

Q: Are we talking a return to the dismal 1970s?

The Fed learned the importance of squashing inflation before it strangles the economy in the 1979-82 period, so a return to '70s-style double-digit inflation is highly improbable. But the U.S. economy could face stagflation – weak growth with stubbornly high inflation – indefinitely.

The Fed's primary tool to combat inflation is to raise interest rates to slow the economy. The economy's weak 1 percent growth rate in the first quarter of this year suggests that an increase in interest rates anytime soon could tip the economy into recession.

Most economists think that the Fed will begin raising rates later this year, but the Fed seems to be betting for now that the current slowdown will keep inflation in check.

Q: Where does the banking crisis fit into all this?

Problems in the banking sector began with the meltdown of subprime mortgages, given to the weakest borrowers. That led to a buyers' strike against every institution holding tainted subprime assets, with investors frowning on everything from shares of bank stocks to mortgage-backed securities sold as bonds. The financial sector is dragging down the broader stock market, much as tech stocks did when the “dot-com” bubble went bust in 2000-2001.

The result is that banks have less money available to lend. Concerns are growing that credit card debt and car loans will go the way of mortgages and see rising delinquencies soon. Banks are socking away greater amounts of capital to offset possible future loan losses, so there's less money available for new loans – for cars, homes or businesses. That further slows the economy and a housing recovery.

Q: Stocks keep skidding. Are we in a bear market?

Bear markets are loosely defined as a sustained 20 percent drop from the peak of a bull market. At the close Friday, the Dow Jones industrial average was about 19.8 percent off of highs set last October. To some that signals the start of a bear market, although technically stocks would have to fall a bit further and stay down for at least two months.

“All we're doing in the stock market is, for the third time, testing the crisis level. We're down to the same level as on January 1st and (in) March and now we're back here again,” said James Paulsen, chief investment strategist for Wells Capital Management, a subsidiary of Wells Fargo Bank. “We are bottoming out.”

Q: So is there any good news?

Lots of it, according to Paulsen, who's more upbeat than most analysts. He points to a large number of indicators that have been better than expected, including retail sales, consumption, capital spending and foreign trade.

“I think the economy is showing signs of bottoming. It's turned the corner,” Paulsen said. “If oil would go back to the $120s, do you realize how good everything would look? If we didn't have this oil spike in the last couple of months, I wonder where we'd be now. I think the negatives are still there, but they're lessening in intensity.”

Q: What about those stimulus checks? Are they helping?

The one-time tax rebates seem to be providing a boost. Many economists now think that second-quarter growth could be 1.5 percent to 2 percent, in part thanks to the stimulus checks washing through the economy.

But everything boils down to housing, oil and banking. If home prices fall at a slower pace, if oil prices drop, if banks resume lending, the economic outlook brightens. If not, the outlook worsens.

“I don't think the economy is going to hit bottom until the fourth quarter,” said David Wyss, chief economist for the rating agency Standard & Poor's in New York. “I think it's a mild recession, but I think it is going to be a longer recession. It's going to drag on.”

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