The erosion in payroll jobs continued in June for the sixth consecutive month, oil prices are still setting records, housing remains very weak, credit markets function poorly and stock prices have resumed their earlier decline. Is there a light at the end of a horrific tunnel?

The economic data shows no signs of a pickup in growth, but it is performing far better than suggested by surveys of household confidence. Economic growth has slowed, but growth remains above 1%, despite an implosion in the housing market, a 50% rise in crude oil prices so far in 2008, and a credit market that remains somewhat impaired. Those few analysts who expected such a dire set of conditions were forecasting a sharp and deep recession. Why has that not occurred? The weakness is extremely concentrated in housing and finance, which makes for great headlines, but accounts for only a small part of the economy. In contrast, manufacturing companies geared towards exports are doing well and consumer spending has slowed, but not gone off the edge of the cliff. So, GDP growth has slowed and jobs are slowly declining, but the adjustment process is being given time to work out the problems in housing and finance.

The data suggest that the housing market is probably not too far from bottom. Unsold inventories of new homes have declined for the last 13 months consecutively! Existing home sales have been flat for six months. Neither of these observations qualifies as evidence of a turnaround yet, but they do suggest we are approaching a bottom in housing. Housing starts have already declined from around 2.2 million units at an annual rate to less than 1.0 million units, even as underlying demographic trends suggest a need for about 1.5 million units per year. Thus, the housing market does not have a great deal of room for a much deeper decline. Evidence of a bottom in housing would change quite sharply peoples perceptions of the economy and the outlook.

The surge in food and energy costs also remains a great concern and for good reason. Much of the growth in household income is being absorbed by higher food and energy prices. This precludes the consumers from invigorating demand and growth more broadly. If food and oil prices were merely to stabilize, real disposable income would benefit and that would be sufficient for a pickup in household spending to provide an impetus for stronger growth. While U.S. policymakers do not control food or energy prices, they could implement policy initiatives that could give a very significant downward push to food and energy prices, as I wrote last week. These include: eliminating barriers to imports of sugar-based ethanol and reducing subsidies on corn-based ethanol, enhancing subsidies on solar and wind power immediately, quickly providing permits to drill offshore in known locations of oil and gas, and moving ahead expeditiously to construct nuclear power plants. As Martin Feldstein explained so eloquently in an editorial in The Wall Street Journal this week, policy actions that increase energy supplies in the future would have a very quick depressing effect on oil and food prices now, because the market would recognize and adjust to the new supplies such policies would imply. (I'm not holding my breath.)

Even without such sound new policy initiatives, the economy is likely to muddle along near-term and improve slowly, as the dislocations in the markets are resolved. The Fed is working behind the scenes to improve liquidity in credit markets. They were making very good progress until conditions weakened a bit in June. They are no doubt considering other initiatives. Even without new steps, time will slowly help, as financial firms have already written off or reserved against huge losses and such firms have raised enough new capital to offset their losses. More loss provisions will be taken, but the lions share of such losses should be behind us. Still, investors will hear all about the losses that will surely be reported for the second quarter, as companies report their earnings results in the coming weeks. Recovery will occur naturally, but policymakers should take more initiatives to help the financial market operate normally somewhat sooner.

The outlook for the stock market is far more uncertain, because it is clear that the recent downtrend is driven by fears over rising energy costs, a weak economy, and more credit losses by financial firms. Such concerns should dissipate once the housing sector appears to be bottoming, partly because it should help growth and relive concerns over even greater mortgage losses. Until evidence of a housing bottom appears, the equity market is sure to remain fairly volatile.

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