By Rich Miller
Sept. 30 (Bloomberg) -- The U.S. may face its longest recession in a quarter century no matter what action Congress takes on Treasury Secretary Henry Paulson's $700 billion plan to rescue the battered banking industry.
Economists including Joseph Lavorgna of Deutsche Bank Securities and David Greenlaw of Morgan Stanley said it now appears the economy shrank in the third quarter as credit- crimped consumers cut spending for the first time since 1991. A further contraction is likely in the next two quarters, some economists predicted, which would make the recession the longest since 1981-82.
``This has been a body blow to consumer and business confidence,'' said Mark Zandi, chief economist at Moody's Economy.com in West Chester, Pennsylvania. ``The next six months are going to be very difficult.''
How bad it gets depends on whether Congress passes some form of assistance for the banks. The Standard & Poor's 500 index plunged 8.8 percent yesterday, its biggest fall since 1987, after the House of Representatives rejected the rescue package. The stock-market rout wiped out a record $1.3 trillion of wealth.
The defeat of the measure -- and the steep price decline that accompanied it -- set off a scramble among the plan's backers for additional support before another vote, which likely won't come until later in the week.
Long and Steep
If Congress ultimately fails to approve a bailout, what is shaping up to be a long and moderate recession might turn into a long and steep decline as credit freezes up and stock prices continue to nosedive, said Allen Sinai, chief economist at Decision Economics in New York.
``We're going through a period of holy terror,'' he said.
The grim outlook puts pressure on Federal Reserve Chairman Ben S. Bernanke and his colleagues to reduce interest rates, following yesterday's move to pump an extra $630 billion into the global financial system.
``They should and will cut rates,'' said John Lonski, chief economist at Moody's Investors Service in New York. Economists at Citigroup Inc. told clients today that they see a ``decent chance'' of European central banks following any reduction from the Fed with ``emergency'' rate cuts of their own.
So far, the economy has largely been able to weather the financial crisis, growing by 2.1 percent during the past year, thanks to well-timed tax relief and healthy corporate cash flow. Both now look to be losing their potency.
Flat Consumer Spending
Consumer spending was flat in August as the boost from $93 billion worth of rebates faded and households grappled with mounting job losses, declining home prices and a squeeze on credit.
Morgan Stanley reduced its forecast for third-quarter gross domestic product and now sees it contracting by an annualized rate of 0.6 percent instead remaining unchanged, Greenlaw said in a note to clients yesterday. The economy grew by 2.8 percent in the second quarter.
Deutsche Bank's Lavorgna also turned more pessimistic after the consumer-spending numbers were announced yesterday, saying the economy looks set to suffer a 0.5 percent decline in the third quarter. He had previously expected a 0.7 percent gain.
``The spending outlook is even worse going forward, given the dramatic tightening in financial conditions that has occurred in the last couple of weeks,'' he said in a note to clients. The outcome could end up looking like the credit- induced slowdown of 1980, when consumer outlays plunged at a 5 percent annual rate over two quarters, he wrote.
Trimming Purchases
Consumers are so pinched they're even trimming purchases of basic goods. Walgreen Co., the largest U.S. drugstore chain, reported on Monday that its profits rose less than analysts estimated after it posted its smallest sales increase in a decade.
Faced with stalling consumer spending and fading profits, companies are also starting to rein in their outlays and pare their payrolls.
Industrial production fell in August by the most in almost three years as slower car sales prompted automakers to cut back on output. Data coming out Oct. 3 are expected to show that jobs declined another 105,000 this month, after an 84,000 drop in August, according to economists polled by Bloomberg News.
Tighter credit is also beginning to take its toll on companies as earnings slow, making them more dependent on loans to expand their businesses.
Financing Gap
The so-called financing gap -- the amount of money companies pay for capital expenditures minus what they generate internally from profits -- rose to an annualized $327 billion in the second quarter from $163 billion in the same period a year earlier, Fed data show.
``Businesses are starting to be squeezed,'' Lonski said.
McDonald's Corp., the world's largest restaurant company, told some U.S. franchisees to seek other ways to finance store improvements after Bank of America Corp. declined to increase lending, according to a memo obtained by Bloomberg.
Even companies that are able to get credit must pay more for it. While Caterpillar Inc. raised $1.3 billion last week in its biggest bond offering ever, it had to offer the highest yields it has paid on such debt in nine years.
Zandi said the combination of strapped consumers and cautious companies may cause the economy to contract by as much as 1 percent in the fourth quarter of this year and again in the first quarter of next.
A bank-rescue package ``is not going to save us from recession,'' said Nariman Behravesh, chief economist at Global Insight Inc. in Lexington, Massachusetts. ``It will only prevent it from getting a lot worse.''
To contact the reporter on this story: Rich Miller in Washington at rmiller28@bloomberg.net
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