Consumer spending has been supported this year by a refinancing boom and strong home equity valuations. But with mortgage rates on the rise and housing prices set to flatten, some economists fear that a deeper retrenchment in spending may be in the cards.

Low interest rates have spurred about $1 trillion worth of refinancings this year, and another $1 trillion of originations.

"There's little doubt that this year's refi's have helped to reliquefy household balance sheets and added to cash flow," said Richard Berner, an economist at Morgan Stanley.

Refinancings should reduce mortgage debt service by $11 billion this year, while cash-out refinancings have put $84 billion into the hands of consumers, according to Berner. Cash-out refinancings enable borrowers to increase the size of their loans and pocket the difference.

Creeping Back

Still, interest rates have risen over the past month, with the average 30-year mortgage rate going from a low of 6.45% in November to 7.09% as of the week ending Dec. 14. Despite 11 rate cuts this year from the

Fed, the 10-year Treasury note stands at 5.39%, up from 5.10% at the start of the year.

"The most visible reason to refinance is because of lower rates," said Maureen Allen, economist at Skudder Kemper Investors. "So the backup will at least give consumers pause."

That said, several economists believe that rates will come back down next year, and while refinancing activity has had an impact on spending, data show that it has added just 0.2% to disposable income.

"I think refinancing is a marginal issue. Real income is still growing at a decent clip, and this has allowed people to spend," said Dan Laufenberg, chief economist at American Express Financial Corp.

The real concern, economists say, is the effect a recession and an increase in unemployment will have on home prices.

The housing market has held up remarkably well this year, with none of the usual falloff in construction or new home sales that has accompanied prior recessions. Average home prices have climbed 6.5% over the last five years and 8.6% over the last two years, according to the Office of Federal Housing Enterprise Oversight. This has created a real wealth effect.

"Consumers aren't saving much out of current income because the increases in housing wealth, just like the increase in stock market wealth in the 1990s, are doing the saving for them," Berner noted. "A flattening in home values could force consumer retrenchment and delay overall recovery."

Dust Bowl

David Orr, chief capital markets economist at First Union, said that national home prices have not seen an outright decline since the Depression, and that he is not looking for this to happen next year either.

"Prices aren't going to fall, but the rate of increase is slowing," he said, adding that he is looking for a 0% to 2% rise in home prices next year.

"The fact that they're not going up will have a somewhat negative impact on psychology, because people perceive how wealthy they are by the equity in their homes," he noted.

Orr expects consumer spending to fall 2.8% in the first quarter and believes it will rise just 0.6% in the second quarter and 1.7% in the third.

Allen said she too expects housing prices to come under pressure as unemployment climbs.

"The rise in rates hasn't shut down refinancing completely, because people still do have a lot of equity in their homes, but you need to see prices rise, and they probably won't," she said. "This will be a big headwind on spending growth."

Indeed, she is looking for a 7% drop in spending in the first quarter, and a "very soft take-off after that."

Berner noted that local housing bubbles are already deflating, particularly in areas such as San Francisco and San Jose, "so there is some risk to consumers from this incipient loss of wealth," he said.

New Customers

Still, economists are not looking for a crash in the housing market, because there are few imbalances between supply and demand. Builders drastically curbed speculative home construction in the 1990s, while at the same time a wave of immigration expanded the pool of first-time buyers, Berner noted.

"Housing prices aren't going to go up as fast as they have been, but we don't have a real estate bubble that needs to crash to bring us back to equilibrium," added Laufenberg.

Meanwhile, economists said any deceleration in housing valuations should be offset to some extent by lower energy costs and tax cuts.

Still, consumers tend to be very sensitive to changes in the price of their homes, because that is where most of their net wealth is tied up. If demand softens along with unemployment, economists say, the effect on consumers, both real and psychological, could become more pronounced.

"The real question is, is there another leg to go in this recession?" Allen said. "If home prices don't decline, the gains will at least disappear, and consumer spending will be weaker as a result."