The Yellow-Light Economy

Who could have imagined that the stock market would hit record highs so soon after the credit crunch and the housing collapse? Or that the credit markets would already have begun opening up again, albeit with a much greater spread than in June between interest on private debt and interest on treasuries?

So where are we in the tug of war between bulls and bears?

The August panic seems like ancient history. It originated in the contagious fear that the pyramid of securities based on subprime mortgages of unknowable worth was wobbly and might collapse. The Federal Reserve came to the rescue by pumping more money into the banking system and lowering interest rates. They judged that the risk of an economic slowdown and a full-blown credit crisis was greater than the risk of inflation. This was the right assessment. The price index for personal consumption expenditures, or PCE—the inflation gauge the Federal Reserve Board watches most closely—rose a mere 1.8 percent in August when compared with a year earlier, well within the 2 percent comfort zone that the Fed looks for and the lowest PCE inflation rate since 2004. Prospects for restraining inflation are good because housing costs, which include rent and make up the biggest component of the inflation index, continue to decline.

The bears, looking at the glass half empty, see corporate America concerned by a still-real risk of contraction. The credit squeeze is eased, but not yet over. In the next 60 days, nearly $1 trillion of commercial paper will have to be rolled over, and nobody is quite sure where the money to refinance it will come from. If business can't access working capital for its daily needs, firms will have to shrink their operations. The business concern over the economy has also slowed payroll growth.

Consumer woes. Households, too, face a series of challenges: Adjustable mortgage rates are likely to cost more over the next 12 months, accelerating the rate of foreclosures; the job market will soften; consumer confidence is in for a decline, particularly as people confront diminished equity in their homes. The number of existing homes for sale at the beginning of October—more than 4.5 million—is twice as many as 2½ years ago, according to the National Association of Realtors. This means owners will have to ask for lower prices before the slump can end, entailing some reduction in all home values. House sales and prices will clearly have a few more quarters of sharp contraction.

The bulls, seeing a glass half full, focus on impressive growth in other sectors: high business profits; growing nonresidential construction; expanding business fixed investments; and soaring exports benefiting from the lower dollar. Inventories are low, and balance sheets are strong. The companies in the S&P 500 alone have $2.8 trillion in cash balances, and returns on equity are still running in the high teens. The corporate world is not coming to an end.

Neither is the consumer, but he's got a lot less in his pocket. The National Retail Federation is predicting the lowest growth in five years in retail store spending in November and December. Still, that's a rise of 4 percent. The bullish point is that in the past five years, household net worth rose $18.5 trillion. Some 80 percent of that came directly from stocks, bonds, mutual funds, pension funds, and insurance policies. The stock market is reaching new highs, so we can expect more spending by the top 20 percent of American earners who own most of the stock. They have a disproportionate influence on the direction of the economy: They spend more in a given year than the bottom three quintiles combined.

So the bears and the bulls are in rough balance. Most accept that the likeliest best outcome is that we will have a couple of quarters of subdued growth and then see a gradual strengthening next year, especially if the housing correction has worked through and doesn't unduly depress consumer spending.

The big unknown—the fulcrum, maybe—is that there is perhaps $500 trillion in outstanding derivatives contracts, some of them in instruments so complex that investor after investor has admitted to not being able to know the value of those newfangled assets. In other words, it will be several more months before the bear-bull tug of war can be resolved.

The Fed was right to be pre-emptive in showing that it will take powerful steps to maintain our economic momentum. The fear that replaced greed in the financial markets has in turn been replaced by caution. But anxiety about recession still lurks. The Fed must be on its toes, ready to move decisively again should the trend lines turn down and signal a broader weakening in output and employment.