Economy to turn in weak 2007 performance

WASHINGTON Thu Apr 19, 2007 7:45pm EDT

WASHINGTON (Reuters) - Turmoil in the U.S. housing market has taken a toll on the world's richest economy and a quick snapback looks increasingly unlikely as businesses cut back on investments and hiring, and consumers spend less.

The economy grew at a respectable pace of 3.3 percent in 2006, but many economists now project that 2007 will see growth just slightly above 2 percent.

"We see an economy that's going to be weaker this year than last year," said Anthony Chan, chief economist at JP Morgan Private Client Services in New York.

A troubling drop in business investment spending, in particular, looks to have held back growth in the first three months of this year.

"Growth is below the economy's potential and will remain so through the fall," said Mark Zandi of Moody's Economy.com in West Chester, Pennsylvania, cautioning that the biggest risk to expansion lies in the fallout that corrections in the housing and mortgage market might have on the broader economy.

"The negative housing wealth effects on consumer spending could be more pronounced than anticipated," Zandi warned, estimating that a third of U.S. households tapped a substantial amount of home equity in recent years to support spending.

But with stagnant or falling home values, and rising mortgage delinquencies, consumer spending's sole support looks to be wage and income growth, and this at a time when households are being heavily taxed with higher energy prices.

Energy costs rose only 2.9 percent in 2006. But in the first three months of this year, they shot up at an annual rate of 22.9 percent, accounting for about 41 percent of the increase in U.S. consumer prices.

LABOR MARKET TO SLOW?

Retail sales rose a solid 0.7 percent in March, but much of the gain was due to higher gasoline prices. In addition, economists said favorable weather conditions have encouraged shoppers.

"We've been helped by favorable weather and that is masking a lot of the underlying weakness we are seeing in housing and capital expenditures," said JP Morgan's Chan.

That "underlying weakness" may begin to make itself more apparent at the same time the labor market begins to soften. So far, however, employment gains have remained solid, even as jobs have been shed in the housing and manufacturing sectors.

"The end of the construction boom means less employment growth overall and that then means less income growth and less consumption," said Christian Weller, chief economist at the Center for American Progress, a liberal think tank.

What businesses will do next is a critical issue for the economy's health moving forward.

So far, the news is less than reassuring.

Orders for nondefense capital goods, excluding aircraft -- a gauge of future business spending -- fell 2.4 percent in February after plummeting 6.2 percent in January.

The surprising weakness in capital spending has raised concern at the Federal Reserve over the possibility its forecast of a "moderate pace" of expansion could miss the mark.

Minutes of the Fed's most recent meeting in late March laid concerns over both lackluster business investment and a rise in delinquencies in the subprime mortgage market on the table.

"Additional evidence of sluggish business investment and recent developments in the subprime mortgage market suggested that the downside risks relative to the expectation of moderate growth had increased," the central bank's minutes said.

Still, the Fed opted to signal it remained more concerned about inflation than growth, for now.

While corporate profits have begun to slow, a further softening may lie ahead. Economists expect business productivity probably will weaken, given that firms have been holding onto their workers despite a slower pace of growth.

That would lead to greater pressure to let workers go.

"What does a business do? What lever does it have to stoke the profits machine? They have to cut back on labor," said Ken Mayland, economist and president of ClearView Economics in the Cleveland area.