The data increasingly support our belief that a recession has begun. Employment dropped for the second consecutive month in February. Factory orders are dropping, and both business and consumer confidence are declining. Housing remains in recession, and financial markets in distress. Oil prices have reached new highs, and we have raised our forecast of oil prices to $91/barrel at year-end.

We still believe that the recession will be relatively short and mild, with the tax rebates bringing it to a premature end. Without the stimulus package and the quick easing by the Fed, this recession would resemble the 1991 downturn. With these aids, we think the recession will be gentler, although still deeper than the one in 2001.

The consumer remains the linchpin. If consumers continue to spend, it may be possible to avoid recession. However, if they stop going to the malls and refuse to spend their tax rebates, this recession could be longer and deeper than expected. Now, consumers are being squeezed by high oil and falling housing prices.

On the positive side, a benign external environment, with foreign growth remaining relatively strong and U.S. exports becoming more competitive because of the weak dollar, should continue to improve the trade deficit. The dollar has dropped to a record low against the euro, which will improve the real trade balance. The nominal trade deficit is not likely to look much better, however, because of high oil prices and the impact of the lower dollar on import prices.

The Federal Reserve will continue to cut interest rates, but inflation is high enough to limit the depth of these cuts. Perhaps more important, Chairman Ben Bernanke has always focused on inflation control as fundamental to any long-term monetary policy. Although he will cut rates now to fight the recession, he will also raise them more sharply after the recession is over, which will slow recovery and create more of a “U”-shaped recession in the economy, with a mild downturn followed by a very gradual recovery.

Will Consumers Cave?
Consumer spending is the base of the U.S. economy, accounting for 71% of GDP. Consumers are getting pinched, as wealth deteriorates because of falling home prices and a declining stock market. Spending power is being eroded by higher food and, especially, energy prices. Savings have been near zero for the past three years. Americans never save for a rainy day until they get wet. Energy prices are the major issue in the short term. Oil hit a record $108/barrel March 10. We have followed Global Insight, whose model we use for our economic projections, by raising the expected price at the end of 2008 to $91/barrel. Even this implies a drop from current price levels, which may prove optimistic if worries about supply continue. The rise in oil prices increases the percentage of household income going to energy to 6.3% in the first quarter from 5.6% two years earlier. This is money that cannot be spent elsewhere.

Consumers are becoming more worried about debt. Fortunately, the worry about mortgage resets eliminating purchasing power has waned, because the Fed’s loosening has eliminated about two-thirds of the reset amount we had expected last summer. The foreclosures so far have come almost entirely before any reset has occurred. In many cases, foreclosures have been on homes whose value has dropped below the value of the original low-down-payment mortgages on them. Owners are treating their mortgage as a put option on the house, and exercising the option if the price drops. If the homeowner has negative equity in the house, because he bought it with 2% down and the price has dropped 15%, he has no qualms about walking away.

But we still have confidence in Americans’ ability and willingness to spend money. With rebate checks coming early summer, people will have some “found money” to spend. Although the life-cycle theory of consumption and surveys of consumers suggest that most of the money will be saved, past experience suggests that most Americans will quickly overcome their good intentions. Analyses of the 2001 tax rebates suggest that about 60% of the money was spent within a quarter. Although many households used the checks to pay down their credit cards, 90 days later their credit-card balances were back up to their original levels.