Recession Alarm Sounds As Economy Shrinks

The economy jolted into reverse during the third quarter as consumers cut back on their spending by the biggest amount in 28 years, the strongest signal yet the country has hurtled into recession.

The broadest barometer of the nation's economic health, gross domestic product, shrank at a 0.3 percent annual rate in the July-September quarter, the Commerce Department reported Thursday. It marked the worst showing since the economy contracted at a 1.4 percent pace in the third quarter of 2001, when the nation was suffering through its last recession.

The latest GDP reading marked a rapid loss of traction for the economy, which logged growth of 2.8 percent in the second quarter, and is sure to buttress the belief of many economists that the nation is in the throes of a painful downturn.

The deterioration reflected a sharp retrenchment by consumers, whose spending accounts for the largest chunk of national economic activity. Consumers ratcheted back their spending at a 3.1 percent pace in the third quarter, the most since the second quarter of 1980, when the country was in the grip of recession.

GDP measures the value of all goods and services produced within the United States and is the broadest barometer of the country's economic health.

While the third-quarter's contraction wasn't as deep as the 0.5 percent annualized decline analysts expected, the poor showing underscored the terrible toll of the housing, credit and financial crises.

Wall Street took the news in stride, pushing the Dow Jones industrial average up nearly 190 points in a relatively calm session.

Meanwhile, the Labor Department said Thursday that new claims for jobless benefits for the week ending Oct. 25 stood at a seasonally adjusted 479,000, the same as the previous week and above analysts' estimates of 475,000. Jobless claims above 400,000 are considered a sign of a struggling economy.

The grim reports come just days before the nation picks the next president on Nov. 4. Whether Democrat Barack Obama or Republican John McCain wins the White House, the incoming president will inherit a deeply troubled economy and a record-high budget deficit that could cramp his domestic agenda.

Many economists believe the economy will continue to contract into next year, which would more than meet a classic definition of recession - two straight quarters of shrinking GDP.

The National Bureau of Economic Research, the panel of experts that determines when U.S. recessions begin and end, uses a broader definition to determine recessions than two quarters of contracting GDP. That didn't happen in the last recession, in 2001. The NBER takes into account income, employment and other barometers. The finding is usually made well after the fact.

A collapse of the housing market and locked up lending have produced the worst financial crisis to hit the country in more than 70 years.

To cushion the fallout, the Fed slashed interest rates on Wednesday by half a percentage point to 1 percent, a level seen only once before in the last half century.

Fed Chairman Ben Bernanke has warned that the country's economic weakness could last for some time - even if the government's unprecedented $700 billion financial bailout package and other steps do succeed in getting financial and credit markets to operate more normally.

Unemployment now at 6.1 percent could hit 8 percent or higher next year. Disappearing jobs, battered nest eggs and retirement accounts, and falling home prices are likely to make consumers retrench even more.

Underscoring the strain faced by consumers, the report showed that Americans' disposable income fell at an annual rate of 8.7 percent in the third quarter, the largest quarterly drop on records dating back to 1947.

In the third quarter, consumers cut back on purchases of cars, furniture, household appliances, clothes and other things.They pulled back after the bracing impact of the government's tax rebates disappeared.

In addition to consumers, businesses cut back sharply in the third quarter. They cut spending on equipment and software at a 5.5 percent pace, the most since the first quarter of 2002, when the economy was struggling to recover from the 2001 recession.

Home builders slashed spending at a 19.1 percent pace, marking the 11th straight quarterly cut back, and fresh evidence of the depth of the housing slump.

Slower growth for U.S. exports - reflecting less demand from overseas buyers who are coping with their own economic problems - also factored into the weak GDP report. Exports grew at a 5.9 percent pace in the third quarter, a sharp deceleration from the second quarter's 12.3 percent growth rate.

The U.S. economic downturn in the third quarter was accompanied by higher inflation.

An inflation gauge tied to the GDP report showed prices - excluding food and energy - rose at a 2.9 percent pace, up considerably from the 2.2 percent growth rate in the second quarter. Although the new reading is outside the Fed's comfort zone, Fed officials predict the economy's slowdown will damp inflation pressures in the months ahead. The Fed has made clear that its primary mission at the moment is reviving the economy.

Banks Borrow Record Amount From Federal Reserve

Banks borrowed in record amounts from the Federal Reserve's emergency lending program over the past week, while investment banks drew loans at a slower pace.

The Fed's report, released Thursday, showed commercial banks averaged a record $111.9 billion in daily borrowing over the past week. That surpassed the old record — a daily average of $105.8 billion — from the prior week.

For the week ending Wednesday, investment firms drew $87.4 billion. That was down from $111.3 billion in the previous week. This category was recently broadened to include any loans that were made to the U.S. and London-based broker-dealer subsidiaries of Goldman Sachs, Morgan Stanley and Merrill Lynch.

The Fed report showed that its net holdings of "commercial paper" came to $144.8 billion on Wednesday. The Fed created a first-of-its kind program, which started Monday, to buy mounds of this crucial short-term debt that companies use to pay everyday expenses. The Fed has said that around $1.3 trillion worth of commercial paper would qualify.

The report also said insurance giant American International Group's loan from the Fed dropped to $83.5 billion, from $90.3 billion last Wednesday, as the company repaid some of the money. The Fed has said it would loan a total of $123 billion to the firm.

Squeezed banks and investment firms are borrowing from the Fed because they can't get money elsewhere. Investors have cut them off, moving their money into safer Treasury securities. Financial institutions are hoarding whatever cash they have, rather than lend it to each other or customers. The lockup in lending has contributed to a sharp slowing in the overall economy.