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Is U.S. economy headed for recession — or not?

As some sunshine broke through the clouds in this week’s global stock market storm, investors remained focused on a flurry of fresh economic data.  By John W. Schoen.
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As some sunshine broke through the clouds in this week’s global stock market storm Wednesday, investors remained focused on a flurry of fresh economic data. Despite some conflicting signals, the question many are asking is clear-cut: Is the U.S. headed for a recession? Or will a slowing economy dodge the bullet of a full-blown downturn?

This week, that question was brought into sharper focus by comments from former Federal Reserve chairman Alan Greenspan — who said Monday that the risk is rising that the U.S. economy could be headed for a recession.

But after a bruising global sell-off Tuesday, the stock market seemed relieved to hear that the current Fed chairman believes that, despite some signs of weakness, the U.S. economy is still on track.

"My view is that taking all the new data into account, that there is really no material change in our expectations for the U.S. economy since I last reported to Congress a couple weeks ago," Bernanke told the House Budget Committee Wednesday. "If the housing sector begins to stabilize and if some of the inventory corrections that are still going on in manufacturing begin to be completed, there's a reasonable possibility that we'll see some strengthening of the economy sometime during the middle of the year."

That’s roughly the view offered by most private economists. Still, some believe that that while the odds favor a so-called “soft landing” — the risk of a recession is rising. Greenspan publicly joined that camp Monday in remarks to a business group.

"When you get this far away from a recession invariably forces build up for the next recession, and indeed we are beginning to see that sign," he said.

Several economic reports out Wednesday brought fresh cause for concern. 

With more complete data now available, the U.S. Commerce Department Wednesday shaved more than a percentage point off its initial assessment of the economy’s growth rate in the fourth quarter of last year. The Gross Domestic Product, the report said, expanded by just 2.2 percent – not the 3.5 percent reported last month.

Fresh data also brought new worries about the ongoing slump in the housing market — which has been the main drag on U.S. growth. Despite hopes of that market stabilizing, sales of new homes fell 16.6 percent in January, the biggest drop since 1994. That helped push the supply of unsold homes to 6.8 months' worth from 5.7 months, according to the Commerce Department.

If the housing market remains weak, other sectors of the economy will have to pick up the slack to avoid recession. But there were signs in Wednesday’s GDP data that businesses are have been pulling back on investing in new equipment. A separate report from a group of purchasing managers showed that slump continuing this month.

“The business investment thing is the real quandary; it's been weak and it was weak throughout the entire second half of the year,” said Mark Vitner, a senior economist with Wachovia Securities. “If the economy is going to stay out of trouble now that the housing market is cooling off, we're going to have to get some strength from business investment if we're going to have a second leg of this expansion.”

On the plus side, inflation remains and unemployment remain low. Wednesday’s GDP report showed “core” inflation — which excludes volatile food and energy prices — at 1.9 percent, a bit lower than originally reported. That means it’s less likely the Federal Reserve will have to raise interest rates again to keep inflation in check — and could even pave the way for a rate cut.

But the Fed may not be in the mood to make borrowing cheaper. Many market analysts believe that this week’s stocks pullback may have been based, in part, on fears that credit has been too easy — and that there’s just too much money sloshing around the financial system. High levels of “liquidity” tend to push stock prices higher and faster than they rise during periods when money is harder to come by. So the “correction” in stock prices, according to this view, was the result of stock prices getting ahead of themselves.

One big sign that money is plentiful is the so-called “credit spread” in the bond market, a sign of how easy it borrow money for everyone from businesses, to governments to private equity funds looking to buy up companies. That spread represents the difference between interest rates on U.S. Treasury debt — considered the safest bet out there — and other, riskier bonds issued by corporations or governments.

Interest rates are typically higher on those riskier bonds, to make up for the greater possibility that the borrower won't be able to pay off the bonds. But lately the bond market has been demanding a much lower “risk premiums” than usual. That's helped spur a borrowing spree on Wall Street, where an attitude of "easy credit" has prevailed, according to Stuart Hoffman, Chief Economist for PNC Financial Services Group.

"(The market) doesn’t care if you’re Brazil or Argentina or some junk bond borrower who’s buying some other company and doing it all by putting down one penny and borrowing the other 99 cents and figuring, ‘If it doesn’t go right, stick [it to] the bond holders,” said Hoffman.

Meanwhile, there are also signs that an “easy money” consumer lending spree may also have gone too far. Defaults by holders of so-called “subprime” mortgages — people with less than stellar credit profiles — have been steadily rising.

"In many cases borrowers were put in a position where basically everything had to go right for the them in terms of rates, their incomes, the value of their home — there was no room for error," said Hoffman. "And with home prices going down and maybe their incomes are still going up, but not as fast as their payment adjusted, many of these loans were kind of doomed to failure if anything went wrong."

The fear is that the fallout from lower housing prices could spread to the broader mortgage market, though Hoffman say that doesn't seem to be happening yet.

Oil reprieve
The U.S. economy has also gotten something of a reprieve from the crushing burden of high energy process. Last year’s surge in the price of crude provided created another major drag. Now, due in part to easing demand from a slowing economy, the recent decline in oil prices has helped keep the slowdown from worsening.

“(Last year) we had a strong global economy and strong economy in the U.S. and that kept oil above $50,” said Steven Schork, an oil market analyst based in Philadelphia. “In that time the markets loved to go to their utmost limit. What we saw last summer — that $70 to $75 range — is as high as oil can go without killing this economy.”    

One of the most important economic report cards is due next Friday, with the release of the latest report on the job outlook. Because consumer spending makes up some 70 percent of the U.S. economy, those consumers’ paychecks are the biggest single force keeping the economy moving. Those numbers are expected to show continued growth in new jobs and wage gains, both of which supply the fuel for economic growth.

“If people feel good about their jobs and their pay is increasing they are likely to continue to  spend which would help the economy,” said Alison Deans, head of investment policy at Neuberger Berman.