The next nine to twelve months will be difficult for the U.S. economy. The recovery is slowing down and fears of a  double dip inflation can take place or double-digit unemployment rate and eroding confidence among many households, businesses and investors.

The Federal Reserve has a few number of tools to help quantitative easing

Despite these serious concerns, the odds still favor the recovery remaining intact and self-sustaining. Businesses are enjoying strong profits and solid balance sheets. If history is a guide, they should boost investment and hiring. Households have also made progress getting their balance sheets in order; decreasing debt service burdens and saving rates are increasing.

The U.S. economy is downshifting. Real GDP looks to be growing nearly 2% annualized—at most—in the current quarter. This rate is down from 3% during the first half of 2010 (before impending downward revisions), and 4% during the second half of 2009. Fading support from the monetary and fiscal stimulus, the waning inventory cycle in manufacturing, and the fallout from Europe’s debt crisis are weighing on the recovery.

The recovery’s weakness is clearly evident in the job market. Abstracting from the temporary ups and downs of hiring related to the decennial U.S. census, job growth has slowed noticeably since the spring.

Layoffs by hard-pressed state and local governments explain part of the slowing, as does the reluctance of private businesses to hire. Hiring has stabilized since sliding dramatically during the recession but remains far below levels expected in a well-functioning job market. The current pace of net job creation will not prevent the unemployment rate from rising in the coming months.

Large businesses appear most reluctant to hire, which seems odd given their better profits, stronger balance sheets, and ample access to credit. This hesitancy may be explained by large firms’ ability to shift jobs overseas and their general unease with the U.S. business climate. Given recent policy debates and legislation covering healthcare, financial regulation, energy and immigration policy—not to mention the impending expiration of the Bush tax cuts—firms appear unsure about the rules of the game, leading them to delay major expansion decisions.

Smaller businesses without significant financial resources of their own are still struggling to obtain credit, which they need to invest and hire. Outstanding commercial and industrial loans continue their two-year decline, and the number of active credit cards, which many small businesses rely on, is shrinking rapidly.

For most big banks, tighter underwriting does not reflect a lack of capital. The nation’s largest banks have raised prodigious sums since the financial panic and appear well prepared, at least as a group, for much larger losses than they are likely to suffer. Delinquency rates have peaked across most types of lending, commercial mortgages being the notable exception. Yet, big banks will be unwilling to lend more—and their regulators will be reluctant to allow it—until unemployment peaks definitively and house prices have stabilized.

Many smaller banks are capital-constrained. They’ve been unable to raise additional capital, and their commercial mortgage losses are large compared with their existing capital. The FDIC will close a couple hundred financially strapped banks per year for the next several years. Yet, small banks remain important providers of credit for small businesses in thousands of communities across the country.

Despite the weak pace of hiring and other headwinds, odds are the economic recovery will remain intact. Indeed, it is not unusual for the business cycle to pause at this point on its way from recovery to expansion. This was the case a decade ago when the economy was coming out of the 2001 tech-bust recession. A burst of growth followed in early 2002, but by the end of that year, the recovery looked stillborn, and there was much hand-wringing about the prospects for a double-dip recession. It was mid-2003 before growth reaccelerated, and not until the end of that year did net job creation resume in earnest.

In 2002 as now, the benefits of fiscal and monetary stimulus measures faded, and the boost from a manufacturing inventory cycle was largely played out. Falling stock prices took a big bite out of household wealth and spending. The runup to the Iraq invasion in the spring of 2003 was a major source of uncertainty. Nervous businesses held back on hiring until it was clear that the war would not upend the economy.

In the end, the U.S. avoided a double-dip recession, because businesses did not resume cost-cutting and layoffs. The key reason they did not was their much-improved profitability. Companies had slashed costs during the downturn, and when demand improved even modestly, profits rebounded. The same dynamic is playing out today. Businesses dramatically lowered costs during the recession. Wider margins combined with somewhat better sales have pushed profits back within striking distance of record highs set in mid-2006.

Better profits have in turn strengthened business balance sheets. Interest coverage ratios for nonfinancial businesses—the share of cash flow going to interest payments—are falling quickly with corporate deleveraging and low interest rates. Cash balances are about as high as they have ever been relative to short-term liabilities.

The recovery remains unstable but there are pockets of the economy that is better than others but nothing else must go wrong. Missteps in monetary and fiscal policy would be fatal. The Federal Reserve is debating whether to resume quantitative easing, and Congress and the administration are considering what to do about the expiring Bush tax cuts.

The key benchmark for the Federal Reserve will be the unemployment rate. Rising unemployment will and should prompt the Fed to resume expanding its balance sheet by purchasing more Treasury securities. The intent will be to push down already-low long-term interest rates and prompt more housing activity, vehicle purchases and business investment.

Congress and the president must act soon or taxes will rise beginning January 1. Almost everyone agrees that a tax increase now makes little sense given the economy’s fragility. Unfortunately, consensus ends there. The president supports permanently extending the current tax rates for all except the highest-income households, while congressional Republicans want the entire basket of Bush cuts to be made permanent.

The prudent middle ground would be to forestall any tax hikes in 2011 and to slowly phase in higher rates on upper-income households beginning in 2012, when the economy will be on firmer ground. This is what is assumed in our outlook; anything else would weaken the recovery.

We will need to lower growth estimates as the evidence that the recovery has slowed down and prompted a modest downgrade for the remainder of this year and into the next. Real GDP growth had been expected to weaken during the second half of 2010, but the slowdown occurred sooner and was more pronounced than expected.

For calendar year 2010, real GDP is now expected to grow to range of 2.5% to 3.0%, down from the 3.1% forecast a few months ago. The calendar year 2011 growth estimate has come down to range of 3.1% to 3.4% but employment and unemployment have not come down as much.

Downside risks clearly predominate. Odds of a near-term double-dip recession, which appeared to be about one in five this spring, are now greater than one in four.

There are good reasons to be nervous about the economy’s near-term prospects. The collective psyche is so frayed that if anything else goes wrong, the economy will backtrack into recession. This isn’t expected, but the odds that it will are as high as they have been since the Great Recession ended.

As of 8/30/2010