Rumbles of double-dip recession

Wall Street's relentless slide, coupled with a loss of confidence by big business, is now threatening to create a rare phenomenon in United States history: the double-dip recession.

While the economy is still growing at the moment, experts say the loss of trillions of dollars in stock value and a series of corporate scandals is creating such pessimism that it could push the US back into recession by the end of the year.

Indeed, Stephen Roach, a forecaster with Morgan Stanley, calls the current environment a "classic setup for a double dip."

The last time such an event occurred was in January 1981, when Ronald Reagan inherited an economy that was just recovering from oil shocks and recession. Only seven months later, his Republican brain trust was faced with yet another downturn that kept the economy moribund for a full year.

Although most analysts don't think the economy is going to falter again, the stock market in particular is at such a fragile and uncertain state that no one knows for sure how far the losses will go. Almost everyday brings another revelation that undermines both investor and business confidence.

On Tuesday, congressional investigators revealed how Citigroup and J.P. Morgan Chase may have helped facilitate the Enron accounting scandal.

Yesterday, this led to another tumultuous opening on Wall Street as investors tried to preserve their capital by moving large amounts of money from stocks into US Treasury securities. This forced interest rates down sharply.

"It's a classic flight to quality," says Bill Sullivan, a money-market economist at Morgan Stanley. "We have broken through the envelope and started to confront rumors of major bankruptcies. They may not be true, but the market psychology is such that they believe them."

Even if the US doesn't slip into recession again, the market malaise and mood of pessimism across the land is having an impact. Analysts generally agree that the economy is losing strength from the charged up pace of the first quarter, when the nation's gross domestic product (GDP) grew at a 6.1 percent annual rate.

Next Wednesday, the government will release its first estimate of second-quarter GDP, which is expected to come in at 2.5 percent. The slower pace is likely to continue through the rest of the year: Most economists project about a 3 percent growth rate.

The impact of a declining stock market on the economy is putting increased pressure on Washington regulators to act.

Yet economists say there's a limit to what the Federal Reserve Board can do: Most don't expect it to lower interest rates in this environment. More likely would be a continued loosening of the money supply.

"We need to make sure our banks are clean – the Fed needs to get in there with Spic and Span – not cut rates, and give the banks more money," says Bob Brusca of Ecobest, an economic consulting business in New York.

Economists are divided over how long the slide on Wall Street can go on before it harms consumer confidence. Some continue to forecast only minor effects.

Economist Mark Vitner of Wachovia Securities estimates lower stock prices will only take .5 percent off the GDP, since he figures that only 10 percent of Americans have "significant" holdings of stock while about 66 percent own their own house.

"The continuing rise in housing values is offsetting the decline in stocks," he says.

But consumer attitudes are already starting to shift as the debris from the stock market makes the news every night. Consumers are now starting to increase their savings rate, especially among people near retirement.

"The data over the next several months will be crucial," says Richard Curtin, director of Consumer Surveys at the University of Michigan.

Some of that data will start to come in next Thursday when Ward's AutoInfoBank reports the July new car sales. Early estimates are for a strong month, helped in part by zero percent financing and other incentives.

"If we don't see relatively strong sales with these rich incentives, that would be a warning," says Paul Kasriel, an economist with Northern Trust Bank in Chicago.

Yet another good indicator, says Mr. Kasriel, is the weekly mortgage application data. So far, the housing market has remained strong, regardless of the stock market's performance.

"With rates as low as they are now, if there is not some strong increase in mortgage applications, that would be another indication the consumer is retrenching," he says.

Morgan Stanley economist Richard Berner argues this is exactly what is happening. At first, he thought the shift would be gradual. Consumers, buoyed by tax cuts and real wage increases, would keep spending. "The risk now is that slumping equity values and falling confidence will prompt consumers to turn more cautious and rebuild savings faster than expected," he says.

Already, some signs indicate this is happening. During the first six months of the year, investors moved $204 billion into savings and money-market accounts despite interest-rate returns of less than 1 percent. That's up about 10 percent from a year ago.

But consumer retrenchment alone won't drive the economy into a recession. Business investment also needs to collapse. Mr. Berner argues that corporations, despite improving profits, are showing signs of hesitation as stock prices fall.

If the doubts persist, they could lead to less hiring and capital investment. Next Friday, economists will get a slightly better view when the government issues the July unemployment report. The jobless rate currently stands at 5.9 percent.