Consumers being squeezed from two sides

Even as wages lagged, consumer spending has increased faster than the overall economy — it now makes up roughly 71 percent of GDP — up from 64 percent in 1998.

To finance spending during that period, Americans leaned more heavily on credit cards, dipped into retirement savings and turned to their biggest source of cash — the rising value of their homes. Over the past decade, homeowners have tapped close to $1.5 trillion in rising home prices by taking out bigger mortgages to convert home equity into spending money.

Now, with home prices falling and lenders pulling back, that gigantic piggy bank is running dry. As the housing slump continues, the impact on spending worsens, accoridng to Robert Brusca, chief economist at Fact and Opinion Economics.

“The problem is what it does to the people who live in homes whose values are falling and what it does to their willingness and ability to consume goods," he said.

The housing slump has also created a lending slump. Mortgage lenders have less money to lend after investors who bought bonds backed by faulty mortgages got badly burned. Now lenders are a lot choosier about who they’ll lend to; From the peak of the lending boom, the flow of mortgage credit has roughly been cut in half, according to Brian Bethune, an economist for Global Insight.

Until mortgage lending picks up again, the housing market will have a hard time getting back on its feet. But until home prices stop falling, lenders are going to remain leery about writing a mortgage on an asset that is still losing value.

“As long as the housing market is weak the lending is not going to be there,” said Bethune. “And as long as the lending is not there the housing market is going to be weak.”

A rise delinquencies and other consumer credit problems have also begun to crimp the flow of car loans, according to Richard Apicella, who tracks car lending at BenchMark Consulting International.

“Maybe they've had a repossession in the past, or maybe they've had unfortunately a foreclosure, or the debt-to-income (ratio) that they're carrying is much higher,” he said. “When banks - which have fewer funds to lend - look at the type of person they can lend money to, fewer and fewer people are going to qualify."

With home equity shrinking and lenders pulling back, government policymakers are running out of options. Despite big cuts in short-term interest rates by the Federal Reserve, rates on many important consumer loans like mortgages and credit cards haven't fallen.

And the Fed’s rate-cutting phase appears to be coming to a close. If food and energy prices keep rising, the central bank may have to reverse course before consumers have stabilized their household budgets. That would leave the Fed with the difficult choice of raising rates to fight inflation — or leaving rates low to try to keep consumers spending.

"The adverse feedback loop that the Fed fears most — namely that a continued sharp fall in house prices produces by a clampdown in bank lending, which then feeds back into outright falls in consumer spending — that key downside risk is still very much in play," said Richard Iley, a senior economist at BNP Paribas. “So it’s very difficult juggling act for the Fed."

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