At Last, The Recovery Is Coming Of Age

In March, 1994, the U.S. expansion will celebrate its third birthday. It looks as if the economy will be able to have its cake and eat it too.

Economic growth in 1994 will be a bit stronger than in 1993, and the icing will be another year of very low inflation. Interest rates may tick up, but the rise will be so small you'll hardly notice. The rest of the industrialized world will continue to struggle, limiting exports, but healthy demand in the U.S., plus corporate cost-cutting, will lift profits. And despite companies' urge to purge payrolls, the economy will create enough jobs to cut joblessness, generate income, and keep consumers spending.

MORE CONFIDENT. Sound like wishful thinking? Not at all. BUSINESS WEEK is even a touch more bullish than the consensus projection in our survey of 50 forecasts (table, page 69). We expect the economy to grow a moderate but healthy 3.2% in 1994, without the growth swoon that marred 1993's performance in the first half. We look for inflation of 2.7%, essentially unchanged from 1993. The yield curve will flatten, as the Federal Reserve makes a couple of small hikes in short-term rates and as tame inflation keeps long-term rates down. And we expect unemployment to dip below 6%, although that excludes the impact of government revisions, due in February, which will shift the rate up slightly.

As we see it, 1994 will be a year when workers feel more secure in their jobs and more confident about taking on debt--elements missing from the consumer outlook for the past three years. But at yearend 1993, confidence turned up, and growth in installment debt was booming, mainly because the U.S. generated about 2 million jobs in 1993, the most in four years.

That job pace should continue in 1994, and the quality of new slots will improve, aided by some hiring in manufacturing and construction. More jobs, plus low interest rates, will buoy demand for housing and durable goods. Still, this is no hiring boom, as companies trim labor costs to become more competitive. "Hiring will stay cautious," says Lynn Reaser at First Interstate Bank Ltd. in Los Angeles, "especially because of the uncertainty over health care."

Health-care reform will dominate the Clinton Administration's agenda in 1994. Businesses are wary that any plan will add to their labor costs, and most economists question whether the reforms will cut the nation's medical bills. "The idea that a bureaucracy can be more efficient than market forces just doesn't wash," says Joseph W. Duncan at Dun & Bradstreet Inc.

Potentially higher employment costs are why companies will keep pushing for greater efficiency. As a result, the surge in capital spending for equipment will continue in 1994. In the past two years, such investment, mainly in computers and other high-tech wares, has accounted for more than 40% of the economy's growth. The boom will be financed by rising profits, more equity financing by big companies, and increased availability of credit to small businesses, as banks compete more for new loan business.

CHEAP OIL. The payoff from this investment and restructuring will be lasting productivity increases that will keep inflation and interest rates low. "Capital investments made in 1993 will show up as productivity gains in 1994," says Maury N. Harris at PaineWebber Inc. As a result, unit labor costs, which are inflation's basic fuel, are likely to grow at 2% or less for the third year in a row. That's less than the projected pace of price growth, so profit margins generally will have some breathing room.

Lower oil prices are the big bonus. If prices in 1994 stay some 15% below the 1993 average--or at about $15 a barrel--the benefits would be a quarter-point more growth and a half-point less inflation, estimates Laura D'Andrea Tyson, who chairs President Clinton's Council of Economic Advisers. Crude-oil prices could stay down, given the weakness in Europe and Japan and given that Iraq--OPEC's second-largest producer--may well be back in the market.

Low inflation will make the Fed's job easier, so the Administration and the Fed could have another year of policy harmony. Edward E. Yardeni at C.J. Lawrence Inc., who expects inflation to dip to 2%, says: "The Fed should just take 1994 off and call in for messages."

BABY STEPS. Most economists, however, think the central bank will look beyond 1994 in an effort to preserve its hard-won gains against inflation, especially if the economy looks solid. By spring, the Fed is likely to begin an ever-so-gentle preemptive tightening of monetary policy. It will probably be a baby-steps approach that follows market rates, similar to its easing strategy in the early 1990s.

A couple of quarter-point hikes in the federal funds rate by yearend is unlikely to roil the Administration, which is already forecasting slightly higher rates, and the economy won't even blink. In fact, a show of inflation-fighting resolve might help hold down long-term rates.

The economy would be a lot stronger in 1994 if it were not for the continuing defense cuts and widening trade deficit. Without the declines in these two sectors, growth would have been 4% in 1993, instead of less than 3%. Both of these drags, however, should diminish in 1994. Also, the three-year slump in commercial real estate has hit bottom, although the climb back will be slow. David M. Blitzer at Standard & Poor's Corp. points out that vacancy rates, while still high, are finally coming down.

Moderate U.S. growth in 1994 will bring in more imports--causing some further worsening of the deficit. Already in the past two years, imports' share of domestic demand has soared to a record 24%. Rising imports are not all bad for the economy, though. They will help to keep inflation in check. That's because America's growing appetite for imports and tons of capacity overseas will hold down goods prices, even as industrial operating rates in the U.S. rise to levels usually associated with production bottlenecks and price hikes.

Foreign trade will also be hurt by the problems overseas. Europe and Japan are about three years behind the U.S. in their recovery process. As happened in the U.S in 1990, recessions in Europe and Japan have exposed structural problems, such as the inefficient use of work forces and excess public spending, that will have to be fixed before those economies can once again compete effectively in the global marketplace. Weakness in Europe and Japan will detract further from U.S. export growth, although robust demand from developing nations in Asia and Latin America will offset some of that fall.

Fewer foreign customers means the U.S. will have to depend upon domestic demand for its fuel in 1994. But with American companies already well ahead in the global competitiveness game, the economy stands to benefit as the rest of the industrialized world picks up. But that's part of the 1995 outlook.