Recession risk up - but still not likely

NEW YORK (CNNMoney.com) -- Moody's Economy.com is forecasting an increased risk for recession in the next six to 12 months due to the subprime mess, which has shaken investor and consumer confidence, bumped up foreclosures and led to a tightening of credit standards for most loans.

Mark Zandi, Economy.com's chief economist, now sees a 40 percent chance of recession, up from the roughly 12 percent chance he was forecasting in August.

Nevertheless he doesn't think the economy will actually sink into recession, thanks to strong corporate profits, an improving trade balance in which exports are now trumping imports, and a willingness among policymakers to act if the economic strain gets out of hand.

Zandi defines a recession as broadly persistent declines in economic activity. "The economy may be contracting now, but for it to be a recession it has to last more than a few months," Zandi said. And it has to broadly affect most sectors.

For now, he thinks the greatest risk is concentrated in housing. "I think the housing sector is going to get hammered," Zandi said. On the menu from now until the end of 2008: lower median home prices, declines in the construction of new homes, and job losses in businesses with ties to the housing industry.

Economy.com is forecasting that foreclosures will peak at 900,000 or so in 2008, above the 750,000 forecast for 2007.

It projects the existing single family median house price will bottom out at just over $200,000 by mid-2008, a little more than 10 percent below its peak in 2005 and the current median of $220,000 today, a level that likely won't be recovered until 2010, Zandi predicts.

He also expects a decline in the number of home sales booked - from the current annualized rate of 6.75 million units to 6 million by the end of 2007. By the end of 2008, Economy.com forecasts home sales will start to exceed 7 million homes a year.

Zandi is optimistic, however, that the economy will steer clear of recession given how financially sound and profitable businesses outside the housing sector are and how well positioned the banking system is to weather problems.

"I don't think consumer spending will fall unless the job market is contracting. And I'm fundamentally optimistic we won't see job loss," Zandi said. (Here's what others are predicting for the job market.)

He does, however, expect slower growth in jobs and hiring, an increase in the unemployment rate and a slowdown in consumer spending.

His forecast for monthly job creation over the next year is an average 100,000 a month in 2008, down from the current average of 135,000. Since the economy needs an average 125,000 to 150,000 new jobs every month to maintain the unemployment rate, he expects the unemployment rate to rise to 5 percent by April next year, up from 4.6 percent today. But even that level of unemployment is indicative of a relatively tight job market, Zandi said in a conference call on Tuesday

As for spending, "retailing activity will remain soft through the end of the year," Zandi said. He's forecasting 1.5 percent growth in consumer spending over the next 12 months, down from an annualized 3 percent recorded in the second quarter.

So, what could tip the scales toward a recession? According to Zandi:

• A further decline in consumer and business confidence;
• A continued drop in the number of adjustable-rate mortgages consumers are taking out, which could indicate the credit crunch isn't easing; and
• A jump in continuing jobless claims to above 2.75 million. As of Aug. 25, they came in at close to 2.6 million.