Recession may already be here

NEW YORK (CNNMoney.com) -- The question for many economists is not if the U.S. economy will fall into a recession. It's whether it already has.

The formal recognition of a start of a recession probably wouldn't come for at least six months if not more than a year, as official judges from the National Bureau of Economic Research (NBER) pour through various economic readings.

But top economists from two of the major Wall Street firms - Merrill Lynch and Goldman Sachs - say recession is likely already here.

The tipping point for both economists was the report released last Friday that showed a sharp jump in the unemployment rate in December, coupled with little growth.

"Friday's employment report strongly suggests that an official recession has arrived," wrote David Rosenberg, North American economist for Merrill, in a note this week entitled "Recession a reality."

He wrote that history points to a recession when the average length of the work week fell in back-to-back quarters, as it did in the third and fourth quarters of 2007. And he said at no time in the past 60 years has there been a half-percentage point climb in the unemployment rate from the low point without a recession following. The latest unemployment reading stands at 5.0 percent, up from 4.4 percent in March.

The traditional sign of a recession is two or more quarters when economic activity declines rather than grows. That hasn't happened - the final reading of growth in the third quarter came in at a healthy 4.9 percent.

The NBER's calculation of when a recession starts and when it ends is far more refined than the two-quarters-of-economic-decline test. It looks at a number of factors, such as employment, real personal income and manufacturing, and comes up with a date pegged to a specific month, rather than a quarter. For example, it judged that the most recent recession ran from March 2001 to November 2001.

There's wide agreement among economists that growth in the fourth quarter fell sharply from third quarter levels, although most still forecast slim growth in the period. But many are forecasting a better-than-even chance that some quarters in 2008 will show declines.

Goldman's senior U.S. economist Jan Hatzius is one of those saying a 2008 recession is likely, with roughly a two-in-three chance. Hatzius is worried about the three-month average for unemployment, which has jumped more than one-third of a percentage point from its low.

"Whenever you've tripped the one-third-percentage point barrier, it's an [recession] indicator that's ten out of ten," he said.

Hatzius is expecting the recession will be fairly mild, lasting only 6 months, with the economy declining by no more than 1 percent in any quarter.

But that is based on his assumption that the Federal Reserve cuts rates deeply and quickly, to 2.5 percent from its current 4.25 percent. He also believes that given election-year pressures, there's likely to be some form of tax cut or rebate to try stimulate the economy.

"If the data is every bit as bad as we're expecting and the Fed for some reason refuses to respond, you could see a more severe recession," Hatzius said.

Hatzius also said he believes that the downturn in housing is nowhere near being played out. Hatzius is forecasting that home prices end up plunging 20 to 25 percent below peak levels. And he said that a further sharp decline in housing prices will hit both consumer spending and credit markets, which are two more reasons he's forecasting a recession.

Of course, there are still economists who believe that the economy is more likely to avoid a recession than sink into one. But even they admit to being more concerned than they were a few weeks ago.

"Our own recession-warning model currently indicates that the odds of a recession occurring in the next six months are slightly greater than 50 percent," said the monthly economic outlook from Wachovia. "That said, we still believe the economy will avoid an outright downturn, as a good part of December's weakness appears to be tied to special factors." It cited severe winter storms in much of the country as one of the issues distorting the latest readings.

Even some other economists who believe a recession is likely, such as Harvard University's Martin Feldstein, the president of the NBER, don't believe the economy has already started to shrink.

"Of course these numbers can be revised, but as long as we have positive numbers for employment growth - very weak but still positive - and for industrial production, when the business-cycle dating committee looks at the evidence, they wouldn't say we're currently in a recession," he said.

Feldstein, one of the fathers of the Bush administration tax cuts passed early in his tenure, is advocating tax cuts and further Fed cuts to respond to the current weakness, even if the economy doesn't slip into recession.

Economist Bob Brusca said that while he thinks there is now a better than even chance that there will be a recession, that doesn't mean the Fed can start slashing rates because of the continued threat of inflation.

"A lot has yet to happen if recession is to kick in," Brusca said. "It may yet happen. But for policy that is not the issue. Policy needs to react to circumstances and that refers to both the inflation and growth profiles."

Other economists point out it's almost irrelevant as to whether the economy fell into a recession in December, or does so a few months from now.

Bernard Baumohl, executive director of the Economic Outlook Group, said that even if the economy avoids a recession, it will do so with very slow growth in 2008. He said it's almost immaterial from that perspective if there is a recession or not.

"It'll have the same painful effect on businesses and households," Baumohl said.