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Slowing economy faces major hurdles

As the engine of U.S. economic growth slows, two of its main cylinders - job growth and consumer spending - still aren't firing. Until they kick in, the  weak recovery is in jeopardy.

As the engine of U.S. economic growth slows, two of its main cylinders — job growth and consumer spending — still aren't firing. Until they kick in, the sluggish recovery will remain in jeopardy.

After a surge in growth late last year fueled by massive government spending, the economic recovery has been losing momentum. On Friday, the Commerce Department reported that Gross Domestic Product, the value of all goods and services produced in the U.S. rose by 2.4 percent in the second quarter.

That’s down from a revised 3.7 percent growth rate in the first three months of the year, and less than the 3 percent growth many economists had been forecasting just a few weeks ago.

Other data point to signs that growth slowed toward the end of the April-June quarter. Housing sales tanked after a government tax credit expired in April, and the job market weakened in June after showing signs of strength earlier in the year. That has many forecasters further ratcheting down expectations for the second half of the year.

“With stimulus spending winding down … it looks like expectations for the third quarter will be reduced,” said Mark Vitner, senior economist at Wells Fargo Securities. “It looks like most folks will be coming in with a forecast for GDP in the current quarter that is under two percent."

Vitner said that would put the economy close to a double-dip recession, in which growth slips back into negative territory after a couple of quarters of expansion.

The hope has been that as the impact fades from the government's $862 billion package of tax cuts and increased public spending, that massive stimulus will carry over to the rest of the economy. Friday’s report offered some optimistic signs that may be happening.

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Business investment up
Investment in plant and equipment by businesses picked up by 17 percent in the second quarter, boosted by heavy spending on new equipment and software. Businesses have also reported strong profit growth for the quarter, as heavy cost-cutting sends more money to the bottom line. That kind of gradual improvement could lay the groundwork for a sustainable recovery.

"The longer that we heal, the more likely it is that we'll continue to heal and start to see more robust growth maybe in 2011," said James Paulsen, chief strategist at Wells Capital Management.

But that won’t happen until businesses move from cost-cutting to hiring. Until millions of new jobs are created to replace the more than 8 million paychecks lost to the recession, consumers won’t be able to restore spending to levels that will keep the economy growing.

“We’re in a classic chicken and egg situation,” said Ed Keon, a portfolio manager at Quantitative Managing Associates. “You need to get a firmer labor market — when companies are hiring and putting some their cash to work — in order to increase consumer confidence. But business people need to see demand before they can go crazy about expanding and hiring more people.”

For the moment, consumers don’t appear to be feeling better about the outlook. Friday’s GDP report showed consumer spending grew by 1.6 percent in the second quarter, down from 1.9 percent in the first quarter.

More recent data point to a steeper pullback. After reaching its highest level in more than two years, consumer sentiment plunged in July to its lowest level in nine months, according to a widely watched survey released Friday from from ThomsonReuters/University of Michigan.

"Overall, the survey data suggest that the current slowdown in spending is likely going to persist well into 2011," said Richard Curtin, director of the surveys.

Housing mired
Other sectors of the economy have yet to show increased momentum from the government’s stimulus spending. Despite two rounds of a generous home buyer tax credit, the housing industry, which typically leads economic recoveries, remains mired at low levels of demand not seen in decades. Persistently low mortgage rates have also failed to spur the kind of pickup in home sales seen in past economic recoveries.

The financial collapse that caused the recession has also left an aftermath that is not typically seen in most recoveries. Homeowners are still struggling to pay down debt and make up for heavy losses in home equity suffered when the housing bubble burst. Prices in many parts of the country are still falling.

Businesses, uncertain about where the economy is headed, are hoarding cash. Despite an unprecedented Federal Reserve policy holding interest rates near zero, credit is tight.

“The fundamental picture of the economy is quite different than any other business cycle,” said David Ressler, chief economist at Nomura Securities. “We're not going to see a snapback in many sectors; housing is going to crawl back.”

The risk that businesses and consumers most fear is that the economy slides back into recession again, sending unemployment higher and profits lower. So far, most forecasters say the odds of that happening are less than 50-50.

Growth forecasts
Some two-thirds of economists surveyed last month by the National Association of Business Economists said they expect the overall growth rate will top 2 percent in 2010. A separate survey of private economists by Blue Chip Economic Indicators came up with a consensus forecast of 3.1 percent growth in 2011.

But the extraordinary causes of this recession bring extraordinary risks that go beyond the possible double-dip scenario. One of the most disturbing was outlined this week in a paper by James Bullard, president of the St. Louis Fed.

With inflation barely visible in the past few months data, Bullard warned the dangers of deflation — when prices tumble either because of a collapse of spending, a decline in the money supply, or both — pushing the U.S. economy into the kind of long-term, downward price spiral that has plagued Japan for more than a decade.

So far, the weak economy has produced the kind of low levels of inflation that the textbooks predict. The risk, Bullard argues, is that the policy the Federal Reserve has been using — targeting low interest rates to stimulate growth — could be steering the central bank toward the very deflation cycle that policymakers are hoping to avoid.

Bullard suggests that the central bank consider returning to a policy known as “quantitative easing” involving massive purchases of government debt to pump more cash into the economy to try to reflate the economy.

In an interview with CNBC Friday, Bullard stressed that he doesn’t see signs yet that deflation is taking hold.

“If the economy continues to recover in the second half of the year and we're growing really rapidly, then this will all go away and we'll all forget about it,” he said. “But that's not the nature of contingency planning. You have to be ready for the opposite case.”