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Housing, Auto Slumps May Defy
Usual Role as Recession Harbingers

By GREG IP and CHRISTOPHER CONKEY
December 14, 2006; Page A1

WASHINGTON -- New home construction is plummeting. Car sales are weakening. Investors have driven long-term interest rates well below the short-term rates set by the Federal Reserve. All these factors are present today, and all have been precursors of past recessions.

But the U.S. central bank and much of Wall Street are now betting that the old rules don't apply, and that a recession next year, while possible, is unlikely.

"This time will be different," Ed Leamer, who heads the forecasting center at the University of California at Los Angeles's Anderson School of Management, predicts in a report. "This time the problems in housing will stay in housing." It's a prediction, he admits, that "keeps us up at night."

Many Fed officials and private economists believe home builders and auto makers are curbing production to trim excess inventories as a temporary response to a drop-off in demand that was unsustainable -- not because climbing interest rates are eroding affordability. If the optimists are right, the industries' troubles wouldn't be signs of broader forces tipping the entire economy into recession. Meanwhile, U.S. exports are benefiting from strong growth among U.S. trading partners, especially in Europe.

The case for optimism was bolstered yesterday when the Commerce Department said retail sales rose 1% in November from October, much more than economists had expected. Bond yields jumped sharply, as investors reassessed their view that the Fed would have to slash short-term rates to protect the economy against recession. That could be an early signal that the divide between the pessimistic outlook of the bond market and the Fed's more upbeat economic assessment is beginning to narrow.

Karen Mac Donald, spokeswoman for Taubman Centers, which owns or manages 23 malls in 11 states, said, "The stores we surveyed have been trending up since Thanksgiving." Last weekend, an internal company report noted, its Twelve Oaks Mall in Novi, Mich., was "busy from the time the mall opened," while the Westfarms shopping center in Farmington, Conn., reported its "strongest Sunday thus far this holiday season."

"The strengths that we have been hearing are [in] electronics, beauty, apparel, and this weekend in particular, jewelry and luxury items gained strength," Ms. Mac Donald said.

To be sure, the economy has slowed. Economists expect it to grow at an annual rate of 2% to 3% over the second half of 2006 and all of 2007, after averaging 3.8% for the prior three years.

Moreover, both the Fed and Wall Street have a dismal record on predicting recessions. Ed Hyman, chief economist at New York investment dealer ISI Group, said, "I don't buy the view that because the housing correction hasn't done much to the economy so far, we've seen the worst." He said both the Fed's rate increases over the past two years and last year's rise in oil prices are hitting the economy with a lag. He expects a slowdown, not a recession, but sees more downside than upside risks to that forecast.

Recessions historically have occurred as the Fed, worried about inflation, raises short-term interest rates sharply to the point they are higher than long-term rates, a phenomenon called an inverted yield curve. Higher interest rates first bite into the most interest-sensitive purchases -- homes and cars -- then into consumer spending more broadly. Eventually, this pulls down business investment and jobs.

Mr. Leamer of UCLA said the housing market is one of the most reliable leading indicators of recession. Construction permits to build new homes are down 29% since August 2005. There have been eight comparable declines since 1950, and seven were followed by recessions.

Yet there are crucial differences this time. Brian Sack, an economist at forecasting firm Macroeconomic Advisers, said yield curves usually become inverted because short-term rates are high relative to inflation and bond investors expect the Fed will be forced to cut them to counteract recession. This time, short-term rates aren't particularly high; it is bond yields that are unusually low. Mr. Sack said that is because bondholders are more confident inflation will remain low and stable, and that growth will also be stable. Thus, they aren't demanding as much of a premium to lend money for long periods.

Mr. Sack said interest rates are "contributing to the weakness in housing, but there's something else on top of that. Activity was advancing at a faster pace than we could understand from the fundamentals. Some of this retrenchment is [a sign of] froth in housing activity coming out of the market."

Mr. Leamer added that unlike in previous housing downturns, credit today is ample, so prospective buyers can easily get mortgages. The Mortgage Bankers Association said yesterday that the number of mortgage applications to buy a home rose last week to the highest level since January, a hint that the housing market is stabilizing.

Similarly, lower automobile sales don't just reflect higher borrowing costs. Cut-rate financing and massive rebates over the past four years have "depleted pent-up demand," said Joseph Barker, a forecaster at CSM Worldwide, an automotive-consulting firm. Customers who "were in the market to purchase a vehicle already have." Efforts by General Motors Corp. to hold the line on prices should boost its profits over the long term, but in the meantime are likely to reduce sales and market share, he said.

Of course, housing and autos make up a sizable share of gross domestic product, and weakness in those sectors alone can take a big bite out of growth.

Dean Baker, a co-director of the Center for Economic and Policy Research, a Washington think tank, said the rise in housing prices was unprecedented. Optimists are "missing the full impact of the housing downturn. They think it's mostly, if not entirely, completed, and I think we've just seen the beginning." He predicted that the economy would enter recession next year, probably contracting in the first and second quarters.

Mr. Baker said housing has boosted the economy not just through construction, but by enabling consumers to borrow against their rising home values. That effect is now waning. Homeowners extracted $113.5 billion of the equity in their homes via mortgage refinancing and other means in the third quarter, according to estimates by Fed economist James Kennedy. That is down by half from a year earlier, and the lowest since the fourth quarter of 2003. His estimates are based on research conducted with former Fed Chairman Alan Greenspan. Their report isn't an official publication of the Fed, which released the data yesterday.

Yet November's strong retail-sales report suggests this drop in "home-equity extraction" has yet to affect consumer spending more broadly. Excluding a surprise 1.2% increase in auto sales and a 2.3% increase in service-station sales driven by higher gas-pump prices, sales were still up a strong 0.9%. Sales of electronics and appliances surged 4.6%, and sales at building-materials stores rose 1.8%, retracing recent weakness driven by a falloff in home renovation.

Electronics retailer Best Buy Co. has been forced to discount many items, and its third-quarter earnings were slightly below analysts' expectations. But the chain raised its outlook for same-store sales for its entire fiscal year based on "solid customer interest continuing into the early part of the fourth quarter."

While manufacturers have recently trimmed production due to auto maker cutbacks and other weakness, many are benefiting from stronger growth overseas. Lincoln Electric Holdings Inc., a Cleveland maker of machines and materials for industrial welding, booked direct exports of $112 million for the year's first nine months, up from $70 million last year.

In recent years, the company has seen demand from China and the Middle East soar, particularly for oil and gas projects. Vincent Petrella, Lincoln's chief financial officer, said new orders have also increased in Europe this year. "Europe for the first time in a number of years is showing good strength," he said.

Thomas Mirow, the second-highest official in the German finance ministry, said in an interview yesterday: "The German economy is experiencing a remarkable upswing....Strong export growth has finally spilled over into domestic demand."

Economists said the recent combination of falling imports and rising exports, if sustained, could add as much as 1% to economic growth in the fourth quarter.

Write to Greg Ip at greg.ip@wsj.com and Christopher Conkey at christopher.conkey@wsj.com

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