Consumers being squeezed from two sides

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Despite the heavy headwinds of higher prices for food and gasoline, falling home prices and worries about losing their jobs, most American consumers are still finding a way to pay the bills. But as economists, business executives and government officials try to figure out where the economy is headed, they’re also wondering: How long can consumers keep this up?

Consumer spending, which accounts for roughly 70 percent of U.S. economic activity, continues to grow, but barely. Personal consumption was up 1 percent in the first quarter after adjusting for inflation, according to Thursday's report on the gross domestic product. But the pace of spending growth has slowed sharply from 2.3 percent in the fourth quarter of last year.

Income growth has also slowed, edging up just 0.2 percent in April — about half the rate logged in March, according to government figures released Friday. The gain would have been weaker without the boost from the initial round of rebate checks hitting taxpayers' mailboxes. Friday's report also showed that consumer spending also slowed to a crawl in April - up just 0.2 percent. After factoring out inflation, there was no gain at all.

Consumers are is no mood to spend if they don't have to; consumer confidence fell to a 28-year low in May, according to a Reuters/University of Michigan survey released Friday. The reading was the lowest since June 1980, when the U.S. economy was in shambles and short-term interest rates reached 20 percent after a decade of rapidly rising prices, erratic growth and high unemployment.

Today, rapidly rising prices for gasoline and other commodities are one of the main reasons Americans are so pessimistic about their finances. But while a number of economists — and many consumers — believe the U.S. is already in a recession, the latest data don’t yet point to an economy moving in reverse. So why are consumers so gloomy?

One reason is that after four straight months of government reports showing job losses, Americans are getting more worried about their jobs, according to Ken Goldstein, a labor economist at the Conference Board, which tracks consumer sentiment.

“If we continue to get even small decreases in jobs, these consumer confidence numbers are not going to turn around this summer or even this fall,” he said.

Though the job market is weakening, it’s still fairly strong by historical standards; the unemployment rate, at 5 percent, is well below levels reached in past recessions. Unemployment peaked at 6.1 percent in the relatively mild recession of 2001; it hit 7.8 percent in the 1990-91 recession and topped out at 10.8 percent in the 1981-82 downturn.

But the job figures don’t tell the whole story: Though unemployment is still low, incomes have not risen as fast as the economy has grown since the last recession. Gains in hourly wages don’t tell the whole story, according to Jared Bernstein, who follows labor issues at the Economic Policy Institute.

“One of the big stories in this recovery was that families weren’t able to find enough hours of paid work to get their income back in line," he said. "So the median family income as of 2007 was about $500 below where it was in 2000.

Even as wages lagged, consumer spending has increased faster than the overall economy — it now makes up roughly 71 percent of GDP — up from 64 percent in 1998.

To finance spending during that period, Americans leaned more heavily on credit cards, dipped into retirement savings and turned to their biggest source of cash — the rising value of their homes. Over the past decade, homeowners have tapped close to $1.5 trillion in rising home prices by taking out bigger mortgages to convert home equity into spending money.

Now, with home prices falling and lenders pulling back, that gigantic piggy bank is running dry. As the housing slump continues, the impact on spending worsens, accoridng to Robert Brusca, chief economist at Fact and Opinion Economics.

“The problem is what it does to the people who live in homes whose values are falling and what it does to their willingness and ability to consume goods," he said.

The housing slump has also created a lending slump. Mortgage lenders have less money to lend after investors who bought bonds backed by faulty mortgages got badly burned. Now lenders are a lot choosier about who they’ll lend to; From the peak of the lending boom, the flow of mortgage credit has roughly been cut in half, according to Brian Bethune, an economist for Global Insight.

Until mortgage lending picks up again, the housing market will have a hard time getting back on its feet. But until home prices stop falling, lenders are going to remain leery about writing a mortgage on an asset that is still losing value.

“As long as the housing market is weak the lending is not going to be there,” said Bethune. “And as long as the lending is not there the housing market is going to be weak.”

A rise delinquencies and other consumer credit problems have also begun to crimp the flow of car loans, according to Richard Apicella, who tracks car lending at BenchMark Consulting International.

“Maybe they've had a repossession in the past, or maybe they've had unfortunately a foreclosure, or the debt-to-income (ratio) that they're carrying is much higher,” he said. “When banks - which have fewer funds to lend - look at the type of person they can lend money to, fewer and fewer people are going to qualify."

With home equity shrinking and lenders pulling back, government policymakers are running out of options. Despite big cuts in short-term interest rates by the Federal Reserve, rates on many important consumer loans like mortgages and credit cards haven't fallen.

And the Fed’s rate-cutting phase appears to be coming to a close. If food and energy prices keep rising, the central bank may have to reverse course before consumers have stabilized their household budgets. That would leave the Fed with the difficult choice of raising rates to fight inflation — or leaving rates low to try to keep consumers spending.

"The adverse feedback loop that the Fed fears most — namely that a continued sharp fall in house prices produces by a clampdown in bank lending, which then feeds back into outright falls in consumer spending — that key downside risk is still very much in play," said Richard Iley, a senior economist at BNP Paribas. “So it’s very difficult juggling act for the Fed."