Recession chatter gets louder

The fear factor has spiked in recent weeks as a series of indicators signal that Wall Street's troubles are starting to spread to Main Street.

By Peter Eavis, Fortune writer

(Fortune Magazine) -- Housing price declines. Slowing job creation. Profit warnings from the country's biggest retailers. To an Econ 101 student, those are telltale signs of an imminent recession. Not surprisingly, the R-word has dominated talk among bankers for weeks.

"We're very close to stall speed in the economy," says Paul Kasriel, director of economic research at Northern Trust. And it's not just the usual Chicken Littles talking about it: Everyone from top auto executives to normally ebullient tech venture capitalists are making noises about the slowing economy.

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Former Treasury Secretary Lawrence Summers, now a professor at Harvard University and a managing director at hedge fund D. E. Shaw, says the risks of a recession, or a downturn that comes close to a recession, "must be one side or the other of 50%." (See correction.)

So what's really happening? By most economists' terms, a recession is defined as two or more consecutive quarters of GDP decline -- something we haven't seen since 1991. By that narrow definition we're not even close. Of 50-plus economists surveyed by research firm Blue Chip Economic Indicators, not one is predicting a recession. They still expect GDP to grow 2.6% next year.

But the broader definition, one put out by the National Bureau of Economic Research, is simply a "significant decline in economic activity, spread across the economy, lasting more than a few months." By that measure, many say the sky is falling.

"This is no longer just a Manhattan thing. It's turning into a Queens and Brooklyn kind of problem too," says Maury Harris, chief U.S. economist at UBS, of the way the downturn in the economy is affecting middle and lower-income households.

Of course, the biggest driver has been the downturn in the real estate market. After 15 years of rising home prices, a cooldown was expected. But the sharp price drops this summer showed that the downturn is deeper and broader than previously thought. In July home prices fell 4.5% from a year earlier, according to the S&P/Case-Shiller home-price index. Since the index began in 1987, the only worse decline was in 1991. "We are only just beginning to see the spillover from housing," says Kasriel.

Housing is closely tied to overall consumer spending. With homeowners facing growing mortgage headaches, there's been a simmering fear that they will curtail discretionary spending. Many retailers had already warned that the second half of the year would fall short of expectations. Then, in a one-two punch in late September, Target (Charts, Fortune 500) and Lowe's (Charts, Fortune 500) issued profit warnings on the same day -- news that sent retail stocks plummeting and created new fears of a broader slowdown.

Another key metric is employment. The unemployment rate, at 4.6%, is not a worry so far. But when August figures showed the number of Americans with jobs had fallen for the first time in four years, it raised fears that the weakness in the economy had spread -- and was probably the main factor behind the Fed's Sept. 18 rate cut.

In fact, that rate cut is one of the most telling differences between today's outlook and that of 1991. Typically recessions follow aggressive hikes in interest rates, a deliberate slamming on the brakes by the Federal Reserve designed to halt consumer price inflation. This time the Fed has raised rates gradually, from a very low level. But because of consumers' big debt binges in recent years, the slightest tightening of the money supply may simply have been too much.

To be sure, not everyone is saying a recession is coming. After all, the S&P 500, driven by tech stocks, is trading close to its all-time high. Dean Maki, chief economist for Barclays Capital, says a surprisingly large proportion of overall personal spending comes from the wealthy, who are not likely to dial back their conspicuous consumption.

So where is the economy really headed? Some cooler heads say the more likely effect is a pullback to slower GDP growth. "It's much harder to get into a recession than people understand," says Drew Matus, senior economist at Lehman Brothers.

Others say recessions are an inevitable outcome of prolonged periods of growth and a way to wring excesses out of the economy. As anyone who balked at paying $1 million for a two-bedroom condo in a hot market would agree, there's nothing wrong with the economy that a few months of stalled growth wouldn't fix.

Correction: An earlier version of this story incorrectly stated that former Treasury Secretary Larry Summers is adamant that there's a greater than 50% chance of a recession. Fortune regrets the error. Back to story. Top of page