The Sharp Slowdown Should Stop Short Of Recession

If you want to make an omelette, you have to break some eggs. The Federal Reserve appears to have taken that truism to heart as it attempts to engineer a soft landing for the U.S. economy.

Midway through 1995, the Fed's goal of slowing growth to a noninflationary pace looks like a fait accompli, but cracked shells are everywhere: Payrolls are dropping. Consumers are a bit more cautious. And factories are cutting output in the face of excessive inventories. A few indicators even smack of recession, raising a crucial question: Is the Fed serving up a delicacy for the markets or a dish that'll turn your stomach?

BUSINESS WEEK thinks the economic outlook will favor both stocks and bonds. On balance, we expect the economy to grow 2.5% in the coming year, a shade above the 2.3% average of the 20 forecasters we surveyed in late May and early June (table).

We look for the slowdown to be sharp but temporary, concentrated in the second and third quarters. Many businesses are holding excessive inventories, as the impact of the Fed's past rate hikes hits demand. Those extra stockpiles must be worked down at the expense of orders, output, and jobs.

A slower economy, however, is sowing the seeds of its own revival. Falling long-term interest rates will buoy housing and create refinancing opportunities that will free up household cash. Also, capital spending, while less robust this year than last, will remain solid. Exports will rebound--with the Mexican crisis now abating--and imports will slow. All this will provide key supports for growth.

STOCKED UP. "Slower growth is unlikely to deteriorate into anything like a recession and should prove temporary," says John D. Walter of Dow Corning Corp. That sentiment is widely shared by economists, mainly because inventories are about the only imbalance in an otherwise healthy economy. Over the past year, businesses built up their stockpiles at the fastest pace in a decade. When demand fell off in the first quarter, inventories became top-heavy. But inventory corrections during an expansion are not unusual. The last one occurred about three years into the long 1982-90 upturn. Economic growth actually turned negative for one quarter.

The 1995 inventory realignment should not take long. New control systems let businesses react faster to overstocking. Moreover, the imbalance between inventories and sales is heavily concentrated in the auto industry. Detroit's already announced cutbacks should have that problem in check by the end of summer. Also, a lot of the excess retail inventories are imports, which will shift the blow of fewer retail orders to foreign manufacturers.

So what will the economy look like after inventories are in better shape? The best bet for the fourth quarter and beyond is a pickup in erowth--not to exceed the "speed limit" of about 2.5% in real gross domestic product that the Fed believes will keep inflation reined in. With current growth apparently dropping well below that pace, the chances are rising that the Fed's next move will be to ease.

Some mild acceleration in inflation, probably to about 3.5% by the end of 1995, up from 2.7% in 1994, seems likely, but the Fed has suggested it will tolerate a small pickup as long as the economy is slowing down. Moreover, efforts on Capitol Hill to balance the budget are likely to exert some drag on the economy beginning as early as fiscal year 1996, which begins in October.

ROBUST EXPORTS. Keeping the economy chugging along will be capital spending and exports. Businesses will continue to invest in high-tech equipment in order to lift productivity--for reasons apart from the ups and downs of the business cycle. Global competition is forcing efficiency. "The recent pickup in productivity is permanent and not just a business-cycle phenomenon," says Michael Keran of Prudential Insurance Co.

And because of increased efficiency, especially in manufacturing, American companies are in a much better position to weather a slowdown. To be sure, profits are set to slow in the coming year from their stellar performance in the past year. But with unit labor costs exceptionally low, profitability will suffer less than in past cycles.

This sharper competitive edge will also make the coming year another good one for exporters. The Mexican crisis dealt U.S. shipments a blow in the first quarter, but export growth will rebound in the second half of 1995. This depends on the expectation that continental Europe's recovery will maintain its recent pace of 2.5% to 3% and that East Asia and Latin America will continue to grow strongly. One worry is a new round of recession in Japan, which could temper growth along the Pacific Rim.

A bigger boost to the U.S. economy, though, will come from the sharp slowdown in imports, as domestic demand wanes. In consequence, the trade deficit is set to improve--a plus for overall growth.

But even with these solid supports from Corporate America and the global economy, consumers will still play the crucial role in how the economy bears up. Fed tightening has already hit household spending hard. Over the past year, outlays for consumer durables and housing are up only 3.2%, down sharply from the 10.1% pace of a year earlier.

Even so, economists are cautiously upbeat. Despite recent weakness, "we still believe consumers will make one more run at the malls," says Maureen F. Allyn at Scudder, Stevens & Clark Inc. May's job drop was not the start of a recession-like wave of payroll cuts. The layoffs were linked to the inventory correction. Once that imbalance has passed, job and income growth will be sufficient to support a moderate pace of buying.

A healthy consumer balance sheet is another force that should prevent recession. The residential real estate market across most of the country will stay solid, supporting house prices. And the rallies in both the stock and bond markets are boosting consumer wealth. The bond rally has also touched off a new burst of refi madness: Home-mortgage refinancings in late May were triple their early-March volume, putting extra cash into people's pockets.

FEELING SCRAMBLED. Consumers, however, will not spend with the same gusto as in 1994. Job jitters will cool the jets of some shoppers. And households took on a record $130 billion in new installment debt in the past year. Add in higher monthly payments on adjustable-rate mortgages caused by past rate hikes, and some households will feel mighty scrambled by 1996.

Of course, any time the economy slows markedly, it becomes vulnerable to shocks. This time is no different. Anything that knocks the pins out from under consumer confidence--from a sudden escalation in U.S. involvement in Bosnia to an additional plunge in the dollar--could be enough to turn the Fed's would-be omelette into dog food. That happened after the Iraqi invasion of Kuwait in 1990. But barring the unknowable, BUSINESS WEEK is betting that the Fed will prove to be a pretty good chef.

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