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Continued consumer spending key to U.S. economic growth

Although the world economy is growing and markets in the United States have shown remarkable resilience, the U.S. economy has entered a period of great uncertainty, according to two of the country's leading economic forecasters. David A. Wyss, chief economist for Standard & Poor's, and James E. Glassman, managing director and senior economist at JPMorgan Chase & Co., presented their views on financial markets and the U.S. economy at the W. P. Carey School of Business's 44th Annual Economic Forecast Luncheon on Dec. 5. Both analysts say that the troubles of the U.S. housing sector have damaged credit markets and put other parts of the economy at risk.

Although the world economy is growing and markets in the United States have shown remarkable resilience, the U.S. economy has entered a period of great uncertainty, according to two of the country's leading economic forecasters.

David A. Wyss, chief economist for Standard & Poor's, and James E. Glassman, managing director and senior economist at JPMorgan Chase & Co., presented their views on financial markets and the U.S. economy at the W. P. Carey School of Business's 44th Annual Economic Forecast Luncheon on Dec. 5. Both analysts say that the troubles of the U.S. housing sector have damaged credit markets and put other parts of the economy at risk.

"There are a lot of negatives out there right now," says Wyss. "I don't think any of them is enough to cause a recession, but they sure are enough to slow things down substantially." Wyss places the probability of recession at 40 percent, up from 33 percent a month ago. "It's hard to see how things get better, and it's easy to see how things get worse," he says.

Glassman sees financial markets as extremely volatile now, as the effects of the subprime mortgage collapse are felt across the financial sector. "Unlike the financial crises we've faced in the last several decades, this one is the most dangerous because it's challenging the idea that underpins our financial system," Glassman says. "This is the idea that you could take loans, package them up, create securities out of them and sell them to people."

One train, many engines

Wyss and Glassman come to their views from slightly different perspectives. Glassman focuses on financial markets, seeking explanations for recent trends in interest rates, currency markets, and the stock market. Wyss tries to make sense of many different variables — from oil prices to trade imbalances to the value of the dollar — to come to conclusions about the direction of the economy.

The two economists agree that focusing too narrowly on the U.S. economy's pluses and minuses can produce a distorted view. Trends in the world economy also must be taken into consideration, they say. "We don't live in silos," says Glassman, noting that a global perspective can explain why the stock market has gone up amidst the turmoil in the housing industry.

"What the stock market is doing is it's looking at the global economy as a whole, and lot of American companies are benefiting from what's going on in China and India." Says Wyss, "The line used to be, 'When the U.S. sneezes the rest of the world catches a cold.' This time around, the U.S. sneezed and the rest of the world said, 'Gesundheit!' and pretty much ignored it."

Ten years ago, the United States represented 25 percent of the world's economy and about 30 percent of world growth, according to Wyss. Today, this country represents about 23 percent of the world economy but only 12 percent of world growth.

"People talk about a decoupling of the world economy, but that's really the wrong term," Wyss says. "If you look at trade flows and financial flows, you see the world is more tightly coupled together than ever. The secret is that there are more engines attached to the train."

Glassman says the strength of other national economies is the main reason the value of the U.S. dollar has fallen — not any fundamental decline in the U.S. economy. "The dollar is doing what it's doing because the world is getting healthier and better balanced," he says. "Our trading partners finally are performing."

Spotlight on consumers

Recent economic data have come in strong, Wyss notes. Real Gross Domestic Product rose 3.9 percent in the second quarter and payrolls increased by 166,000 in October. The third quarter numbers do reveal a troubled housing market, but this has been counterbalanced by improvements in the U.S trade deficit.

Looking ahead, Wyss says, the biggest variable is the behavior of the American consumer. "So far the consumers have been hanging in there, supporting the economy in the good old-fashioned American way of living beyond their means," he says.

Whether consumers will continue to spend is the big question. "Consumers are getting squeezed — between higher mortgage costs, mortgage payments, falling home prices, and rising energy costs," Wyss says. "I don't think it's going to stop them, but it's going to slow them down a bit."

Glassman and Wyss have both taken a hard look at the rapidly rising price of oil and what it might mean for the U.S. economy. Wyss says he expects the price of oil to go down but has little confidence in the prediction. "If I've discovered anything over the last few years it's that I'm really bad at forecasting oil prices — and so is everybody else," he says.

The good news, according to Glassman, is that although the price of oil has quadrupled, the effects have been contained. "The world wants more oil so oil is going to be more expensive — but it's not driving other prices up because we have a lot of spare capacity," he says.

Retailers and manufacturers have found ways to keep consumers spending. "We find that the more I've got to pay at the pump, the more Wal-Mart has to offer concessions or the more the auto industry has to make concessions," Glassman says. "This is not exactly your classic inflation problem."

All eyes on the Fed

Wyss sees some inflation risk, linked to the dollar's slide, which he expects to continue at least into the first half of 2008. "It raises directly the price of imported goods and also it gives domestic manufacturers some cover to raise their prices," he says, adding, "Inflation is not at the top of our list right now. What's closer to the top of our list unfortunately are the problems of the financial markets."

The Federal Reserve appears ready to set aside concerns about inflation and attack the problems of financial markets, according to the analysts. The board's vice chairman Donald Kohn said in a recent speech that the panel was prepared to be "flexible and pragmatic" in dealing with the credit crisis — a statement that caused many analysts to believe rate cuts were coming.

"When you have moments like that you say to yourself, 'Well, it's dangerous, it's uncertain, but maybe if the Fed recognizes it in time and is willing to be aggressive, it can defuse much of the danger,'" Glassman says. Wyss predicts the Federal Reserve will cut interest rates twice in the coming months. "That will help. Whether it will help enough, we'll have to see," he says.

Bottom Line:

  • The subprime mortgage collapse and problems in credit markets have created an air of uncertainty around the U.S economy despite strong second and third quarter data this year.
  • Economic growth in other countries has helped the United States withstand the troubles in credit markets and other areas. Growing economies elsewhere have a greater demand for U.S. goods and services.
  • Consumer spending is a key to U.S. economic growth. Consumers are being squeezed by higher oil prices and mortgage costs, and a slowdown in consumer spending is possible.
  • Even with the recent oil price hikes, inflation does not appear to be a pressing issue now. The Federal Reserve appears prepared to cut interest rates to ease the current credit problems.

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