Signs of faltering US economy surface

When the Fed convenes Tuesday, it could signal how it might respond to the slowdown.

The economy is losing its umph as summer winds to a close.

For one, it's looking as if the downturn in housing is spreading to other parts of the economy. Investors, watching this happen, are becoming increasingly nervous and more selective with their loans.

The tightening of credit standards is taking place at a time when trends in consumer spending and the labor market are sending mixed signals.

These developments create a complex challenge for the Federal Reserve governors, whose role is to stimulate the economy in times of trouble. The Board of governors meets Tuesday to set interest rate policy. Already, the bond market has factored in an interest rate cut or two by December – if not by October.

Although the Fed is not expected to reduce rates tomorrow, it might send a signal that it will do so in the future if the central bank decides a slowing economy is a greater risk than inflation.

"Whenever the growth rate has slowed this much, the Fed has cut interest rates," says Paul Kasriel, chief economist at Northern Trust Co. in Chicago. "By the end of October, I think the GDP will have slowed to under 2 percent, and that will be the catalyst for the Fed to act." Gross Domestic Product (GDP) is the market value of all goods and services produced within the country.

One of the problems for the Fed is that some of the economic indicators are ambiguous. For example, last week the Labor Department reported that the economy had created 92,000 jobs in July. Wall Street had been expecting closer to 135,000 jobs. The actual unemployment rate ticked up to 4.6 percent from 4.5 percent.

However, government job creation dropped significantly – a factor that could be adjusted next month. "If you look at the private payroll numbers, they increased 120,000," says Drew Matus, an economist at Lehman Brothers in New York. "Overall, the message suggests the labor market in July was as healthy as it was in June."

But Mr. Kasriel sees signs the downturn in housing is now spreading.

He cites slow car and truck sales, a weakening recreational boat market, and slowing domestic sales of Harley-Davidson motorcycles. "It's spreading to freight haulers who are reporting weaker volumes. Caterpillar is reporting weaker domestic sales because of a slowdown in construction, and ad revenue is down for newspapers in part because of diminished real estate advertising," he says.

Consumers did not contribute much to the economy in the late spring and early summer. But again, the information is somewhat ambiguous. The International Council of Shopping Centers estimates July sales probably increased about 3 percent, helped by summer clearance sales, back-to-school shopping, and price promotions.

But economists are not so sure the consumer has the income to keep going to the mall. The latest employment and hours-worked numbers indicate only ho-hum gains in income, says John Silvia, chief economist at Wachovia Corporation in Charlotte, N.C. "Consumer income is not doing very much," he says. "The consumer side of the economy is OK, but just OK."

When the Fed meets Tuesday the central bankers will also be discussing the inflation rate. In June, the headline inflation rate was up 0.4 percent but the core rate – the inflation rate without energy or food inflation, was up 0.2 percent.

As of June, the Consumer Price Index was up 2.7 percent on a year-over-year basis.

"If you include food and energy – and I think it's legitimate to include it if it rises every month – then inflation is of some concern to the Fed," says Kasriel.

Dollar signs

The Fed has also indicated it is keeping an eye on the dollar since the sliding greenback could result in a higher inflation rate.

"Every time there is a hint the Fed will ease, the dollar gives way," Kasriel adds. "The Fed does not care where the dollar is, but does care whether the weaker dollar will generate higher inflation in the US."

Problems in the financial markets, for many economists, are the most worrisome signs for the economy. Last week, American Home Mortgage of Melville, N.Y., said it would lay off 6,000 employees and stop taking applications for mortgages.

Then, on Friday, a credit rating agency downgraded the debt of Bear Stearns, an important Wall Street investment bank. In recent weeks, the company has had to close several funds that invested in subprime mortgages, loans made to people with marginal credit scores.

After the downgrade of Bear Stearns, the stock market fell sharply with the Dow Jones Industrial Average closing with a 281 point drop. Some economists wondered if the Fed would have to reassure investors as much as it did in 1998 and 1987 after stock market shocks.

A silver lining?

The corporate debt market, however, started to show some signs of life. Last week, for example, Cerberus Management was able to borrow about $10 billion for its purchase of Chrysler. Despite the transaction, Andrew Cole, director of Asset Management Allocation at Baring Asset Management in London, wrote clients Friday to tell them it could take several weeks, if not some months, for the system to get back to normal.

However, Mr. Cole added that "despite the recent spasm in the credit markets, there is no reason yet to expect a credit crunch."