The Growth Scenario: Nice And Easy

Sheriff Alan Greenspan knows that inflation can be one tough hombre. That's why the Federal Reserve Chairman and his posse have been peppering that notorious bandit with a round of warning shots. The question now: Did the economy get caught in the cross fire?

As BUSINESS WEEK sees it, the economy will not escape unscathed from the Fed's four hikes in interest rates since February. But for the coming year, at least, it should keep chugging along at a steady, if slower, pace.

BUSINESS WEEK expects the economy to grow 2.9% in the coming year, measured from second quarter to second quarter, a shade higher than the 2.7% average of the 20 forecasters we surveyed in early June (table). If this quarter's growth comes in as expected at about a 31/2% annual rate, the economy's pace over the past year will have been a much sturdier 4%.

Almost all forecasters expect some degree of slowdown, but the timing varies. Indeed, "the range of opinion on the economy, inflation, monetary policy, and the markets is very wide at present, and there's little on the horizon to narrow it," says Donald H. Straszheim at Merrill Lynch & Co. That's a formula guaranteed to keep the financial markets unusually volatile in coming months. As it is, the Fed's hikes have already hit many investors in stocks and bonds, both in the U.S. and around the world. A weaker dollar has also hurt.

We believe that growth will slow to below 3% by the fourth quarter and remain there through the first half of 1995. A big reason is that the Fed's tightening has some sectors nursing flesh wounds, and one big booster to consumer spending--mortgage refinancing--took a shot through the heart. Interest-sensitive sectors such as housing, autos, and home-related durable goods won't be the same big players in coming quarters that they were last year. After all, it was low rates in 1993 that finally energized this previously anemic expansion.

Despite higher rates, the economy retains enough momentum to keep generating jobs, incomes, and profits. That's why consumer spending, especially on nondurable goods and services, and business investment in equipment will continue to power growth. In particular, in the effort to streamline operations and cut costs, companies' push toward new technology will fuel another year of strong growth in capital spending for equipment. But even here, outlays are unlikely to keep rising at the 18% annual pace they logged during the past year. That's especially true in the face of higher borrowing costs, an uncertain equity market, and somewhat less bullish profit growth as the economy slows and pricing power remains almost nil.

Consumers are unlikely to maintain their revved-up pace of spending as well. They have lifted their inflation-adjusted outlays for goods and services at an annual rate of about 4.5% for three quarters now, although aftertax income rose only 2.9%. That disparity has dropped the savings rate's six-month average to a puny 3.7% of aftertax income. So consumers may choose to start rebuilding their nest eggs.

Moreover, "the housing recovery is over," says Gary L. Ciminero at Fleet Financial Group Inc.--and with it go the heavy outlays on durable goods that fueled the recent spending spree. But now that consumers have bought beds, refrigerators, and cars, they will have to purchase the linens, food, and tune-ups that accompany those big-ticket items.

Of course, housing was set to slow in 1994 even before the rate runup. After all, the homebuilding upturn is already three years old, and the smaller twentysomething generation has fewer people in the prime home-buying age group. Now, higher rates assure that housing is peaking, and homebuilding may even be a drag on growth in the second half. The two percentage point increase in 30-year fixed-rate mortgages since last October has raised the qualifying annual income for a $100,000 mortgage by a hefty $7,000.

RARE FEAT. Also, 1993's low interest rates will not be around to soften the blow from fiscal drag, as they did last year when the bond market rallied in response to the Clinton Administration's efforts to narrow the federal budget gap. Now, long rates are back up sharply, even as the shrinking deficit continues to drain stimulus from the economy.

Slower growth is exactly what the Fed has in mind, but history carries a warning. For the second time in six years, the Greenspan Fed is attempting a rare feat: By hiking rates, the central bank is trying to keep inflation on the lam without tipping the economy into a recession, which is where nearly all past tries at a "soft landing" have ended up.

This time may be different. To begin with, in an unusually bold move, the central bank acted well before any evidence of inflationary pressures. Annual consumer price inflation is only 2.4%, and price pressures may still be held in check even after more than three years of economic growth. First, the improving underlying trend of productivity is holding down unit labor costs. Also, overseas competition is limiting price hikes, and offshore and foreign capacity makes supply bottlenecks less likely.

Not only that, the increase in the overnight federal funds rate--the Fed-controlled anchor for money market rates--is one of the steepest four-month hikes on record. The rate has risen from 3% on Feb.4 to 4.25% currently. All this raises the odds that growth will moderate and that little further tightening is needed to keep policy in the "neutral" setting the Fed desires--neither stimulative nor restrictive.

We expect no more than a further half-point rise in the funds rate this year. If so, the duo of slower growth and tame inflation will calm the recent selling frenzy in the bond markets both here and abroad. Those forecasters who see stronger growth and a later-arriving slowdown, however, see much more Fed tightening--with federal funds at 5.5%--and still higher bond yields.

Amid a cooler pace of domestic spending, however, the economy can count on a little more help from demand overseas. By this time next year, the now nascent recoveries in Europe and Japan will have more punch, and U.S. exporters will feel the lift. The problem: A flood of imports will offset much of the growth impact of greater exports. So, the Merican trade deficit will get worse before it gets better, increasing the dollar's vulnerability. Indeed, another round of dollar weakness, and its inflationary implications, is a wild card in the outlook that could upset the touchy financial markets and possibly lead to more Fed tightening.

REBOUNDING CRUDE. Another surprise could be higher oil prices, stoked by economic recoveries in Europe and Japan, and by a delay in Iraq's reentry into the oil market. "People had talked about $10 oil," says Charles Lieberman at Chemical Securities, "but already prices have rebounded to more than $18 per barrel." In addition, Michael R. Paslawskyj at CIT Group warns that an eyeball-to-eyeball confrontation with North Korea would slam consumer confidence just as the Fed is trying to slow the economy, in what would be an eerie replay of the gulf war recession scenario of 1990.

But barring any shocks, the coming year should be to the liking of households, businesses--and policymakers. The Clinton Administration will worry less about rising interest rates, and the Fed should be able to hang up its guns for a while and enjoy the tumbleweed roll of slower, noninflationary growth.

       Percent change in real gross domestic product
                                                        1994          1995    IIQ`94
                                                   II    III   IV    I     II IIQ`95
      CHARLES LIEBERMAN Chemical Securities        4.5   4.4   3.9   3.6   3.4   3.8
      JASON BENDERLY Benderly Economic Associates  4.7   4.7   4.0   3.5   3.0   3.8
      DONALD RATAJCZAK Georgia State University    4.0   4.0   3.5   3.6   3.2   3.6
      PAUL W. BOLTZ T. Rowe Price Associates       4.3   3.4   3.6   3.2   2.8   3.3
      MICHAEL R. ENGLUND MMS International         4.0   3.0   3.5   3.0   3.0   3.1
      NANCY J. KIMELMAN Technical Data             3.2   3.0   3.4   3.0   3.0   3.1
      MICKEY LEVY Nationsbanc Capital Markets      4.5   3.7   2.6   3.0   2.8   3.0
      DONALD H. STRASZHEIM Merrill Lynch           3.5   3.1   3.0   2.8   3.0   3.0
      JAMES C. COOPER, KATHLEEN MADIGAN BW         3.4   3.1   2.8   2.9   2.6   2.9
      CONSTANTINE SORAS NYNEX                      4.1   3.0   2.5   3.3   2.3   2.8
      LAURENCE H. MEYER Laurence H. Meyer & Assoc. 3.5   3.1   2.7   2.7   2.8   2.8
      STUART G. HOFFMAN PNC Bank Corp.             4.0   2.5   2.6   2.8   2.8   2.7
      SUNG WON SOHN NorWest                        4.0   3.5   2.5   2.5   2.0   2.6
      DAVID M. BLITZER Standard & Poor's           3.9   3.5   2.6   2.4   1.2   2.4
      PHILIP BRAVERMAN DKB Securities              2.5   2.0   2.0   2.5   2.5   2.3
      GARY L. CIMINERO Fleet Financial Group       3.5   2.3   2.4   2.1   2.3   2.3
      KENNETH T. MAYLAND KeyCorp.                  3.1   2.8   2.2   2.0   1.5   2.1
      HOWARD KEEN Conrail                          2.7   2.1   1.1   2.1   1.5   1.7
      MICHAEL R. PASLAWSKYJ CIT Group              3.0   2.3   1.8   1.5   1.2   1.7
      ROBERT H. PARKS Robert H. Parks & Associates 3.0   3.0   2.0   0.0   1.0   1.5
      AVERAGE                                      3.7   3.1   2.7   2.6   2.4   2.7
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