The Wall Street Journal-20080206-Recession Fears Intensify- Service-Sector Index Hits Six-Year Low- Further Rate Cuts Seen as Dow Drops 2-9-

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Recession Fears Intensify; Service-Sector Index Hits Six-Year Low; Further Rate Cuts Seen as Dow Drops 2.9%

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Recession worries surged, slamming financial markets, amid signs that service businesses -- from hotels and retailers to banks -- may be stumbling in both the U.S. and Europe.

In the U.S., a key barometer of the strength of the service sector dropped to its lowest level since October 2001, and suggested those businesses are now contracting. In Europe, a similar indicator fell to a four-year low.

The readings fanned fears on Wall Street that the U.S. is about to tip into recession, if it hasn't already done so, particularly startling analysts who had viewed services as the nation's last bastion of economic growth.

In response, stocks tumbled, with the Dow Jones Industrial Average skidding 370.03 points, or 2.9%, to close at 12265.13. The Standard & Poor's 500-stock index fell 3.2%, and the Nasdaq Composite Index shed 3.1%.

Yesterday, the Institute for Supply Management said its index of nonmanufacturing business activity, which is based on a survey of purchasing managers in service industries, fell to 41.9 in January from 54.4 in December. That was the sharpest decline in the survey's 10-year history. (A reading below 50 indicates the industries are shrinking.)

Anthony Nieves, senior vice president of supply management for Hilton Hotels Corp. and chairman of the survey, said the data took him by surprise. "Did I anticipate this? Absolutely not," he said in a conference call with reporters. "But we're just reporting what our members are telling us."

In Europe, a service-sector index compiled by the Royal Bank of Scotland and NTC Economics in London dropped to 50.6 from 53.1, reflecting particular weakness in financial-services businesses. Adding to the gloom was the weakness of retail sales in the 15 countries that share the euro. Euro-zone sales declined for the third straight month in December and were down 2% on the year.

The data reinforced expectations that the Federal Reserve will cut its target for the benchmark federal-funds rate, at which banks lend to each other overnight, to 2.5% at its March 18 policy meeting from the current 3%. A cut before then is also possible. And futures markets yesterday put the odds of another one-quarter-percentage-point cut in late April at about 68%. Since mid-January, the Fed has lowered rates by 1.25 percentage points amid intensifying concerns about the economy.

In a speech to bankers in Charleston, W.Va., yesterday, Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, said that further rate cuts "ultimately may be warranted." He also said that while he could see the "possibility of a mild recession," he thought it was more likely that the economy "would skirt the boundary of a recession."

Federal Reserve Chairman Ben Bernanke is to testify Feb. 14 before the Senate Banking Committee on the state of the economy and financial markets.

Economists are expressing increasing concern about the nation's economic health. "Normally when the economy starts to weaken, households slash spending on pricey items first," like cars, furniture and other goods, said Bernard Baumohl, managing director of the Economic Outlook Group LLC. "But . . . there is always a need for medical care, transportation, communications, banking, and even haircuts."

"That's why this latest plunge in the ISM service index is all the more alarming," Mr. Baumohl added.

"The sharp drop in the ISM non-manufacturing index . . . is either screwy data or confirmation of recession, if we don't see a reversal next time around," Goldman Sachs economists wrote in a note to clients. "If the move [isn't revised next month] then it suggests a significant and sudden broadening out of the weakness in the U.S. economy."

Some economists are predicting that the economy in coming months will grow slowly -- but not contract. "We come down on the side that the economy will skirt an outright recession, suffering two quarters of growth below 1%, with growth firming over the remainder of 2008," said Macroeconomic Advisers in a note to clients.

The service sector has grown in importance in recent years as Americans have shifted more of their spending to health care, travel and entertainment, as well as an array of personal services. About 60% of consumer spending -- the largest component of the U.S.'s gross domestic product -- goes for services, with the rest spent on goods.

In one hopeful sign yesterday, Walt Disney Co. reported increased revenues at its theme-parks division in the quarter ended Dec. 27, despite the current economic turmoil, and Disney Chief Financial Officer Thomas Staggs said the company hadn't yet seen signs of a slowing economy in theme-park attendance.

The latest European data will increase the pressure on the European Central Bank to follow the Fed's lead and consider cutting its key interest rate -- now at 4%. ECB officials meet tomorrow, but markets expect them to hold rates steady in light of recent inflation data. The inflation rate hit a record 3.2% in the euro zone in January, well above the central bank's preferred range of just below 2%. Markets expect the ECB will cut rates -- but not until June.

The disappointing performance of the service sector "must ring alarm bells within the ECB and increasingly focus the bank's attention on the worsening growth outlook," wrote Howard Archer, chief European economist at Global Insight in London, in a research note. ECB President Jean-Claude Trichet is expected to elaborate on the ECB's outlook at a news conference tomorrow, following the central bank's decision on interest rates. In the United Kingdom, meanwhile, the Bank of England is widely expected to cut interest rates tomorrow by another one-quarter percentage point, its second cut since December.

A steep slowdown in Spain -- the consequence of a local housing bust -- prompted the government there to begin formulating an economic- stimulus plan for the sector; other European governments are beginning to talk about similar efforts.

In addition, the spreading economic slump is certain to be discussed in Tokyo this weekend at a meeting of finance ministers and central bankers from the Group of Seven major industrial powers.

In the U.S., among the 15 service industries included in the ISM survey, only two -- utilities and educational services -- reported growth in business activity last month.

Respondents to the group's survey were asked how "you and your management feel about the next 12 months compared to 2007." Some 42% said worse, another 42% said the same, and 16% said better. More than 85% of the companies surveyed said turmoil in financial markets isn't affecting their ability to obtain financing.