Growth or recession in 2007?

WASHINGTON -- Housing has been a key engine of the U.S. economy in recent years. Now that the housing market has slowed, will the economy sputter to a stop?

That issue is sharply dividing economists, because no one is sure what impact the slowdown in housing will have on consumers, and thus the broad economy. The difference of opinion is leading to an enormous amount of uncertainty heading into the new year, with some economists predicting a recession and others forecasting continued growth.

Pessimists, such as Dean Baker, co-director of the Washington-based Center for Economic and Policy Research, argue that spillover from the housing slowdown will be great in 2007 as consumers pull back spending.

Optimists, such as Carl Tannenbaum, chief economist at LaSalle Bank in Chicago, say the contagion from the declining housing market will be minimal as consumers see their paychecks rise, helping to fuel spending.

The good news is that far more economists are in the optimist camp than the pessimist camp. Although a handful, such as Baker, are predicting the economy will slide into a housing-led recession next year, the majority anticipate the economy will continue to grow, albeit at the slowest pace in at least four years.

Such a softening in the economy means the unemployment rate will likely edge higher, and inflation will ease. The Federal Reserve may be forced to cut interest rates to buoy the economy, meaning borrowing costs could fall for items such as mortgages and credit card debt.

A significant slowdown means that for many Americans, the economy won't feel that great, even if it's not in recession, says David Rosenberg, North American economist at Merrill Lynch.

"It's not the flu, it's not pneumonia, but it's still a little bit of a chill," he says. Rosenberg expects the economy next year will grow at just about half the rate as in 2006.

Challenge for forecasters

There's no doubt the housing market has dropped swiftly. Sales of previously owned homes are estimated to be down 8.6% this year from 2005, while sales of new homes are down 17.7%, according to the National Association of Realtors. Prices, meanwhile, have fallen after posting double-digit gains for years.

"No question, housing is in a recession," Global Insight chief economist Nariman Behravesh says.

But most economists say that recession will not spread to the overall economy. In a poll of 21 prominent economists conducted by the Securities Industry and Financial Markets Association (SIFMA), the respondents expected economic growth of a median 2.5% in 2007, down from 3.3% in 2006.

But the difference of opinion is big. In the survey by SIFMA, the estimates for gross domestic product growth ranged from 1.6% to 2.9%.

"In transition periods, which we are in now, forecasting is very difficult," says Lyle Gramley, senior economic adviser at Stanford Washington Research Group.

Housing's impact on consumers is the issue dividing economists.

The housing market influences consumers in a number of ways, including acting as a job engine in construction, real estate and other industries. It also acts as a catalyst for consumer spending, which accounts for 70% of U.S. economic activity. Economists differ on the extent of the spending impact.

While the economists in the SIFMA survey expect consumers will continue to spend next year, New York University professor Nouriel Roubini, who is forecasting a recession in 2007, predicts the opposite: "While other parts of the economy are in recession, consumption is going to be the last shoe to drop."

But housing won't drag down the entire economy, says Ken Simonson, chief economist at the Associated General Contractors of America.

"People have exaggerated the importance of housing," he says. "But now we have a lot more areas of strength in the economy."

The issues:

*Less equity. Consumer spending in the past few years has been supported by homeowners using their homes as ATMs, either in the form of large profits when they sell, by refinancing at higher dollar values and cashing out the difference between the value of the old mortgage and the new one, or by taking out home equity loans reflecting their homes' higher values.

With prices flat or falling and sales down, consumers will be taking less money out of their home equity.

Mortgage equity withdrawal fell in the third quarter to the lowest level in nearly three years, according to Federal Reserve estimates.

*Debt. U.S. households' debts in relation to their income has steadily climbed in recent years, in part as consumers have taken on more mortgage debt, according to the Fed. That ratio will likely increase as homeowners with adjustable-rate mortgages see their payments increase in coming years.

*Wealth effect. The decline in home prices is also likely having a psychological effect on consumers even if they don't plan to sell their home or take out a line of credit. Just watching the homes around them sit for longer on the market and go for less money than they did a year ago may make homeowners feel less in a spending mood.

But the extent of this so-called wealth effect is up for debate.

If home prices were to fall 10%, returning to mid-2005 levels, "Households would feel worse off and probably would consume less," John Makin, chief economist at Caxton Associates, wrote in a recent paper published by the American Enterprise Institute.

He estimates that such a decline would shrink GDP by 0.4%, not counting the direct effects of the drop-off in housing, such as in those who lose jobs in housing-related fields or the fewer furniture purchases as people stay put and have less of a need to redecorate. Still, he puts the odds of a housing-led recession next year at 50-50.

Baker, however, is far gloomier.

"I don't really see how consumers can maintain their rate of spending," he said in a recent panel discussion on the economy at the Center for American Progress.

"I think we might have a very severe recession."

Optimists prevailing

But the majority of economists are more optimistic. Wachovia's Mark Vitner notes the downturn in the housing market isn't a nationwide phenomenon, instead affecting certain pockets of the economic geography. That means the impact of the housing downturn on consumer spending will be more limited.

And LaSalle's Tannenbaum argues that consumers are finding other ways to keep their shopping habits going. A tight labor market means wages are rising. If inflation moderates along with the economy, as expected, that means consumers will have more money to spend, he argues.

"For most, this (decline in housing) is not representing a serious detriment to the extent that it is being replaced by good income growth," Tannenbaum says.

"I know that housing is coming down," says Tom Adams, CEO of language software firm Rosetta Stone, noting that his wife, Alexandra, is a real estate agent.

"I know there is downward pressure," Adams says, "and some of the froth in the economy is going to get taken out. But I still think the potential for (business) is significant."

That sentiment was echoed in a recent survey of CEOs conducted by the Business Roundtable. On average, the CEOs anticipated growth of 2.8% in 2007.

"Growth seems to be in pretty good shape, just a little bit of a slower range" than in 2006, says Harold McGraw, chairman of the Business Roundtable and CEO of McGraw-Hill.

John Derrick, research director at U.S. Global Investors in San Antonio, says the current slowdown in the economy is just a "normal part of the cycle" that is setting up the economy to continue to expand in coming years.

"We're just due," he says, adding that the worst of the slowdown will soon be over. "If we haven't had the recession yet, we're probably not going to have it."

Economic strengths

There are a number of things working in the economy's favor.

*Stocks. Stock prices will add to their gains from this year by rising in 2007, according to a survey of 40 economic forecasters conducted by the Philadelphia Fed Nov. 17-30. Such gains can help boost consumer spending, as investors see gains when they sell and feel wealthier as they see their portfolios expand.

"There's a wealth effect throughout the economy, because most all of us have 401(k)s," Jim Steiner, managing principal at wealth management firm Lowry Hill in Minneapolis. "Any small incremental amount leads us to be slightly more confident."

*Exports. A decline in the value of the dollar, combined with steady growth in economies around the globe, is expected to boost U.S. exports. Wachovia economists predict net exports will support U.S. GDP for the first time in 12 years.

*Profits. Corporate profits rose more than 30% in the third quarter from a year ago, according to the Commerce Department. Strong corporate profits allow businesses to invest and hire, helping to strengthen the economy.

Companies and investors are showing a "degree of enthusiasm and optimism" that corresponds with continued profit growth, says Bob Davis, managing general partner at Highland Capital Partners, a venture capital firm, and former CEO of Terra Lycos.

"I'm optimistic for the next year," he says.

*Interest rates. Although the Federal Reserve raised interest rates 17 times from June 2004 to June 2006, rates are still at a historically low level. Plus, a number of economists, including those at Merrill Lynch, Goldman Sachs and Global Insight, predict that Fed Chairman Ben Bernanke and his colleagues will cut rates at least once in 2007, making borrowing, and spending, easier.

"It's easy to borrow money at these interest rates. So there's a lot of money available," Sempra Energy CEO Don Felsinger says.

Such positives will keep the economy out of recession in 2007, despite the decline in the housing market, economists say.

"The evidence is already in on the housing market," Edward Lazear, chairman of the White House Council of Economic Advisers, said at a briefing for reporters last week. "We have suffered, actually, very large declines in the housing market, and yet it hasn't transmitted to any other parts of the economy. We know that the economy is robust. We know that the economy is resilient. We know that it's able to offset the declines in one sector."

Even some of those who are predicting recession say it might not be that bad. Parsec Financial chief economist Jim Smith, for example, sees a mild downturn, marked by a swift upswing in the economy at the end of 2007. "It's 2001 all over again, which is the mildest recession we ever had," he says.

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