A Recession? You Bet -- but It'll Probably Be Short and Mild

Some parts of the country will get hit a lot harder than others, and it will take them longer to recover.

By Jerome Idaszak, Associate Editor, The Kiplinger Letter

March 21, 2008

We're forecasting a mild, short contraction ending well before the year is out. With housing and lending industries hurting, factory production and retail sales falling, employment shrinking and consumer incomes slowing, there's no question that a recession is under way. But relief is already in sight.

Still, some parts of the country will be hit a lot harder than others. In states that led the housing boom, including Florida, Nevada and Arizona, as well as Southern California, thousands of jobs in construction and real estate services are disappearing as home values fall. Frost Belt states are in pain, too, especially Michigan and Ohio because of troubles in the beleaguered auto manufacturing industry.

But look for a turnaround soon, with expansion returning in the second half of this year. The fiscal stimulus from Washington and the accumulated interest rate cuts by the Federal Reserve plus other moves will translate into a 2.5% growth in the economy for the third quarter and a similar pace in the fourth quarter. Next year, though, we expect a tepid 2% or so gain in gross domestic product, and it may feel even slower to some. John Silvia, chief economist with Wachovia Corp., says, "We're still working through the housing crisis, and we've got credit problems to deal with."

With election pressures intensifying, Washington will use more tools to boost growth. The odds are rising for a second fiscal stimulus package. Legislation would be aimed at extending unemployment benefits, increasing food stamps and funneling some aid to the states to help homeowners and create jobs.

A federal bailout of besieged homeowners is also gaining steam. Democrats plan a big push in April for legislation that would provide up to $300 billion worth of guarantees so that those behind on their mortgage payments and living in homes whose values are plummeting won't end up in foreclosure. Existing lenders would take a big hit, recovering at most 85% of current market value, and most Republicans oppose the plan. But pressure to help homeowners is mounting, especially since the Fed threw a lifeline to troubled investment banker Bear Stearns and opened the path for other Wall Street firms to tap the Fed's lending window. President Bush still resists, but he has signaled some willingness to compromise, and several actions in recent weeks have been undertaken, despite previous White House opposition.

That's the case involving mortgage giants Fannie Mae and Freddie Mac. The administration is reducing the required levels of capital reserves at each in an effort to stimulate more lending to home buyers. Limits on the size of loans that Fannie and Freddie can accept have also been raised a lot. Earlier this year, the Bush administration opposed both measures.

The problem is that an estimated 8 million homeowners this year will owe more on their mortgages than their home is worth. Finding themselves "under water," many will be tempted to walk away. That would add to the large number of unsold homes and further drive down prices. Policymakers must halt that vicious cycle, says Mark Zandi, chief economist with Moody's Economy.com.

Meanwhile, the Fed will remain bold in trying to keep credit market woes from spilling over from big banks to smaller ones. More rescues along the lines of the Bear Stearns move are likely. Rescuing Bear Stearns was essential to keeping markets afloat, according to former Fed governor Lyle Gramley. "If the Fed hadn't done it, the cascading effects [on financial markets] would have been disastrous."

And the Fed is poised to make more interest rate cuts, which help lower costs for homeowners with adjustable rate mortgages and home equity lines of credit, as well as many small businesses whose existing loans are linked to the prime rate.

The Fed is taking a couple of huge risks. In continuing to trim interest rates, it adds to downward pressure on the dollar at a time when the U.S. needs to encourage foreigners to buy U.S. stocks and bonds. Further, pumping lots of credit into the financial system will add to inflationary pressures once the economy starts to recover. But officials, led by Fed Chairman Ben Bernanke, clearly think the risk of a steep recession must be dealt with first.

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