Fed reduces recession threat

The US economy appears to be on track for a "soft landing" – a period of recession-free but less energetic economic growth.

The job market is now tepid, consumers are tempering their spending, and inventories – from women's apparel to computer hard drives – are starting to rise. The housing sector is the only major concern as developers cancel projects and homes go unsold.

But signs of a benign slowdown are a success story for the Federal Reserve, which has been gradually putting the brakes on the economy.

"The good news of the soft landing is that there is no recession even though there is pain," says Anthony Chan, chief economist at JPMorgan Private Client Services in New York. "There is life after a soft landing."

The slowing economy coincides with declining oil and gasoline prices. Last week, oil prices closed at $71.14 a barrel, down $3.24 for the week. Gasoline prices also fell sharply – dropping 8 cents a gallon, according to GasPriceWatch.com. Falling energy prices will help give consumers some relief from what seems like continuous prices hikes.

This week, economists will look at July sales of new and existing homes as well as durable goods orders – both good barometers of investment spending.

"The new data will give us a sense of how hard the landing will be in housing, and both measures together will give us a sense of how soft the soft landing is," says Mark Zandi of Moody's Economy.com in West Chester, Pa.

In the coming weeks, the Fed will be watching the data closely to see if it can extend its August pause in interest rate increases for the rest of the year.

In the past, the Fed has had difficulty engineering "soft landings." Its last success was in 1995. "The economy today looks very similar to then," says Scott Brown, chief economist at Raymond James & Associates in St. Petersburg, Fla.

The now-and-then similarities were not lost on investors last week as the stock market staged a rally. For the week, the Dow Jones Industrial Average gained 293 points, closing at 11,381, its highest level since mid-May. "The performance of the market is still consistent with the view of a soft landing," says Mr. Chan. "What the markets are telling us is we have a Goldilocks economy – not too hot and not too cold."

In recent weeks, investors have been less optimistic about the bond market. Long-term bonds now yield less than short-term bonds. In Wall Street parlance, this is known as an "inverted yield curve," since long-term bonds have historically had higher returns. If this were to continue for several more weeks, Zandi says, it could augur a recession because banks will become reticent to loan money given the low long-term returns compared to their short-term borrowing costs.

"It has always presaged a downturn and never falsely presaged one," he says.

Based on the stock market, the yield curve, and other economic indicators, Zandi estimates the odds of a recession to be about 25 percent.

Zandi says one of the reasons to be optimistic is the high profitability of American business, which has made balance sheets flush with cash. "Except for General Motors, Ford, and the airlines, profitability has never been stronger," he says.

Muscular earnings statements are spurring businesses to invest in new plants and equipment. "Business investment has not slowed down," says Stuart Hoffman, chief economist at PNC Financial Services in Pittsburgh. "It's another reason we expect the economy is not in jeopardy of a hard landing."

Businesses can feel confident about investing in part because they can export a lot of their products into a robust world economy. Even Japan and Europe, areas that have lagged in the past, are in stride. "It's rare to find such strong growth everywhere," says Zandi.

The greatest uncertainty facing the economy comes from the housing market. Economist David Rosenberg of Merrill Lynch believes the sector is already in a recession. Zandi agrees the sector is contracting. "The risk is that a correction turns into a crash," he says.

Economists will also be watching the consumer sector closely. Last week, most forecasters were surprised when a University of Michigan consumer survey found plunging confidence. "I think it was the early brush of uncertainty in the Middle East," says Chan. "But, with the fragile cease-fire in place and the current trend to lower energy prices, I don't think such declines are fully sustainable."

Dropping consumer confidence is a bit of a mystery to the White House as well. On Friday, President Bush met with his economic team at Camp David for one of his periodic updates and strategy sessions. Treasury Secretary Henry Paulson, in a press conference on Friday afternoon, said he thought the president does not get credit for the economy because "many of the Americans are not feeling it in terms of their own economic situation" particularly rising healthcare and energy costs.

Office of Management and Budget Director Rob Portman also said he thought polls showed a "disconnect" between how people feel about the economy and how they feel about their own personal situation. This chasm, he believes, is the result of the White House not "communicating" the strength of the economy.