The Fed has lowered the interest rates, but that doesn't mean banks are playing ball.Richard Berner, chief U.S. economist at Morgan Stanley, says thewillingness of banks to grant loans is more important than lower interestrates. Now that banks are finally easing their credit policies, he says,more businesses will be able to take out loans for capitalspending, which he sees as an essential ingredient for an economic recovery.Berner maintains that we are in a global recession and doesn't foresee theeconomy improving until early next year. He says U.S. corporations won'treturn to significant capital spending until the first quarter, corporateearnings won't pick up until the second quarter and inventory liquidations won't beover until sometime during that period. In anticipation of these improvements,the market may move slightly higher by the end of the year, to end the yearflat. But not until the first or second quarter, Berner says, will we really, finally, be out of the woods.For the economist's thoughts on the economy, the stock market, capitalspending and "the bottom," read on. (This interview has been edited for length and clarity.)

Most other economists have been harping on the Fed rate cuts as cause for optimism about a pending economic recovery. But you say you look at interest rates in combination with three other factors: the value of the dollar in foreign markets, asset prices and credit availability. Can you tell us what these factors, combined, are telling you?

Richard Berner:

I add up those four factors, and they are telling me thatwe're starting to see an easing in financial conditions. But there's a lagbetween the time you start to see an improvement in financial conditions andthe time the economy starts to recover.

It's not enough to have an easing monetary policy, although that'simportant. Having those other things follow is also important. Some centralbanks look at interest rates and the dollar in what they call a monetaryconditions index. There are people who certainly try to add in the role ofstock prices in thinking about financial factors affecting the economy orfinancial conditions.

The one that I focus on more than other people is credit availabilityand credit spreads. It's hard to quantify that, but I think there's somework that shows the Fed senior loan officers' survey is a reasonable proxyfor credit availability. And when you take that into account, you see thatover the past six months, credit availability has improved, but from afairly restrictive level. So it's going to be a while before that starts toshow up in improved market activity.

"If people are turned down for loans, then it doesn'tmatter what the interest rates are."

Do you have any sense of when that might occur?

Richard Berner:

I think we'll start to see more vigorous growth in thefirst quarter of next year. I think we'll have a return to positive growthfrom declines in the economy in the fourth quarter because I anticipate thethird quarter will show a decline.

Why do you believe that credit easing is so important?

Richard Berner:

It's not just interest rates that affect whether peoplecan borrow. If people are turned down for loans, then it doesn'tmatter what the interest rates are. So the availability of credit is veryimportant, whether you're looking at people or businesses.

Why, given the economic conditions right now, would banks be willing to make loans? Has creditworthiness declined?

Richard Berner:

They are always willing to lend to what they feel arecreditworthy borrowers who, they believe, have good prospects of paying theloan back. But there's no mistaking the fact that banks have become morecautious, reflecting the economic backdrop and its implications forcorporate and household credit quality.

Creditworthiness has declined, compared to two years ago. Compared tosix months ago, corporate credit quality has begun to stabilize or improve,but that's defined by the way that bond investors have begun to look at it.That's because companies have begun to cut back severely on capital spendingand have cut costs elsewhere, laid people off. They've done things that willenable them to preserve the cash flow to service the debt. That's the waybond investors look at it.

How does corporate debt refinancing factor intocreditworthiness?

Richard Berner:

There's been an enormous amount of refinancing,particularly locking in longer-term, low-rate financing and paying downshort-term debt. And that's been very helpful to corporations because iteliminates the interest-rate risk that arises from holding short-termliabilities if the rate on those liabilities is going to go down. I don'tthink it's going to go up anytime soon, but if you eliminate that risk, thenyou can sleep easier at night as a chief financial officer. That's alsohelped households, by the way. Households have been refinancing theirmortgages. Some of them have been able to reduce their debt service as aresult.

"I think that between the second quarter and the third quarter, wewill see the economy getting slightly worse, but not a lot."

What about the inventory liquidation process? Do you think we are nearing the end?

Richard Berner:

I think we're in the middle of it. I think we've got acouple more quarters of inventory liquidation ahead of us. The debate isover how long it will last, and my view is that it will last longer becauseinventory-to-sales ratios are higher than most people are willing toconcede. The second, subtler part of the debate is how intense it will be. Ithink that in the third quarter it could be every bit as intense as it wasin the second quarter. But I think there's more work to do.

As to when we will be through with it, I would argue that we won't see areturn to inventory accumulation until next year. The fourth quarter shouldbe a transition period. Companies will still be liquidating theirinventories, but that's because they will be hesitant to have productioncatch up to demand, and inventories will finish being liquidated as demandslowly improves.

Where are we with capital spending?

Richard Berner:

Right now they are mostly negative. The fundamentalsinclude the prospects for growth, the returns on investment that companiescan earn (and therefore what their profits and profitability look like),cash flow and the cost of capital.

I don't expect capital spending to improve until sometime next year. Myguess is that we shouldn't start to see capital spending turn around until thefirst quarter of next year. But that's still a forecast.

In recent weeks, some economists -- citing a smattering of mildly positive data -- have said they think we may be at a turning point that could poise us for a recovery by year-end. They've cited increases in the Conference Board's leading economic indicators over the past four months, new housing activity hitting an 18-month high and factory output stabilizing after nine monthly declines. How do these factor into your outlook?

Richard Berner:

I am pessimistic near term, optimistic longer term.

All those data that you just described are part of a bottoming process,which we are working our way through. I look to see if the economy isgetting worse, and I think that between the second quarter and the third quarter, wewill see the economy getting slightly worse, but not a lot.

I think we'll see signs of stability ahead, but some of those thingsthe optimists have cited might turn down again -- factory output, for example,after seeing some signs of stability in July. So, yes, we have set thefoundation for healthy growth, but it's not going to appear until next year.

What that means for the market, I think, is that there are going to be allkinds of questions about a rebound in corporate profits. I don't see theyear-over-year comparisons in corporate profits turning positive until thesecond quarter, when the comparisons get a lot easier. The biggest declinein corporate profits will probably occur in the third quarter of this year.

The stock market will eventually begin to anticipate some improvement,but every piece of negative news we hear has a negative effect onperceptions about profits. This implies a market that might be movingsomewhat higher sometime between now and the end of the year. We've said allalong we thought this year would be a flat year. We are currently down 10%,so we certainly could move up 10% between now and the end of the year andvalidate that forecast.

"The difference between this eventual recovery and previous ones is there are still big parts of the equity market, particularly technology, that are still expensive."

Is there a chance that the recovery could be delayed beyond the first quarter or second quarter of next year?

Richard Berner:

Sure, there's a chance. How big is that chance? At thispoint, I'd say it's one in five. But the difference between this eventualrecovery and previous ones is there are still big parts of the equitymarket, particularly technology, that are still expensive. The way wedescribe it is valuation risk in technology and earnings risk in the oldeconomy.

But despite those risks, it seems to me that this market has been wayoversold. When we finally start hearing some good news, I think that will bea catalyst for the market to start to improve.

What are the chances that a global recession could further hammer our economy?

Richard Berner:

We're in a global recession. The way we define it,calibrated by the way the IMF

International Monetary Fund defines global growth, anything below 2.5% is a global recession. And we figure we aregrowing perhaps as slowly as 2% this year. So we're in it, and I think itis having an impact on our economy and the markets are starting to pricethat in.

But it's the U.S. that will lead the world out of this world recession,and it will be lower interest rates, tax cuts, lower energy prices and anend to some of the things that have been holding the economy back that willmake that happen.

What about consumer spending? Do you expect it to continue to hold up?

Richard Berner:

I believe declines in consumer spending have bottomed,and I don't look for retrenchment at this point. Obviously, there are somedownside risks if companies lay off people more aggressively. That wouldchange the consumer-spending picture. But there are some positives out therethat are likely to sustain consumer spending growth in the 2% to 2.5% rangebetween now and the end of the year, and they include the factors I havediscussed.