Soggy Sentiment Blurring Outlook for Recovery

With the U.S. economy cooling more quickly than anyone expected and many people fearing it will get cooler still, American consumers and businesses have turned into a fairly glum lot recently.

Across the board, measures of consumer confidence have fallen, and they've fallen fast. The University of Michigan's sentiment index registered the third-largest two-month drop in its history Friday, and observers were quick to note that its first- and second-largest drops had occurred in the midst of recession.

Businesses are similarly dour. Manufacturers are cutting back production, and layoffs, as measured by Challenger Gray & Christmas' monthly survey, surged in December. The Philadelphia Fed's Future Manufacturing Activity Index, a measure of what businesses in its district believe business will be like a half-year from now, has declined to levels not seen since the downturn of the early 1990s.

Economists consider sentiment a coincident or lagging indicator. It's not like people and businesses look into the future, see a downturn and then get bummed out -- we're simply not that good at forecasting. Instead, as the downturn happens, or a little after it starts, our outlook sours. Nevertheless, sentiment surveys provide an important snapshot of what's happening in the economy.

When the October retail sales report came up short, many economists reckoned that it was simply a pullback from a strong September, and consistent with a soft-landing scenario. When the Michigan sentiment survey showed a big drop in early December, however, they realized they were dealing with a more severe downturn.

The Feeding

More importantly, a decline in sentiment can presage further slowing in the economy, because as consumers and businesses cotton on to the fact that things are cooling, they cut back on their spending. The classic modern example of how this works is Japan, where pessimism over the economic outlook has been a major contributor to a decadelong funk. The rate at which sentiment has fallen in the U.S. suggests to some that the economy will deteriorate further.

"Both consumer and business expectations seem to be deteriorating dramatically, and those types of response, for obvious reasons, can just feed on themselves," says Morgan Stanley Dean Witter chief economist Stephen Roach. "The risks are this recession will deepen."

Yes, Roach believes we're already in a recession. But he also believes that aggressive rate action will fairly quickly shore up the economy, even in the face of declining sentiment. Unlike Japan, where rates are so low that monetary authorities have little room to move, the Federal Reserve has 600 basis points to play with and, as evidenced by its intermeeting cut earlier this month, it has no apparent compunction against playing hard.

That's an important thing, because most economists reckon that without further cuts, which will effectively put new money to work in the economy, things could get rough. "Businesses and are pretty aggressively cutting back production and labor," says Banc of America Securities chief economist Mickey Levy. "As long as that continues, sentiment will be pretty poor, and of course it does feed back into consumption patterns."

Rebounds=Rings

The rate at which consumer sentiment, and thus consumer spending, can rebound will have a lot to do with what happens to the labor market. Even if the economy at large is coming back, people who are worrying about whether they're going to be getting a paycheck will cut back spending. One big reason the recovery from the last recession got off to such a sluggish start was that the jobless rate continued to climb steeply for more than a year after the economy hit bottom. Because employment tends to lag behind the economy, it may be that in the present case, too, consumption will be slow to reaccelerate. That could mean that the salad days for companies dependent on people's discretionary spending, like retailers and consumer cyclicals, could be a while off.

"Consumer spending is not going to come roaring back any time soon," says Moody's Investor Services senior economist John Lonski. "If anything, its recovery will be mild."