The Fed's Soft Landing Has Room To Glide

In the 1972 movie The Candidate, Robert Redford sells his soul to win an election. In victory, he turns to his handlers and says simply, "Now what?" You could ask the Federal Reserve the same question about the economy.

The Fed-engineered "soft landing" is here. By keeping real interest rates relatively high, the central bank has slowed the economy enough to create some industrial slack and short-circuited inflationary pressures. But even under the tight monetary reins, the expansion shows no signs of stumbling into recession.

The latest data show more evidence of the soft landing. Retail sales are rising modestly. Factory output has bounced back (chart), and inventory growth has slowed. Inflation, meanwhile, isn't even in gear--it may even be in reverse--partly because some of the rise in domestic demand is being satisfied cheaply by imports and partly because of bargain-conscious consumers.

O.K., so now what? By all indications, the Fed seems content with the status quo. And given the higher trend in productivity and the absence of cost pressures, policymakers may tolerate growth somewhere between 2 1/2% and 3%, at an annual rate, over the next few quarters, without worrying too much about inflation. Recent reports suggest that is where the economy is headed.

If not for the 1996 budget, now under hot debate, the Fed might be inclined to keep policy on hold for a while. But if Washington delivers a credible package of deficit reduction, the Fed seems ready to offset the resulting fiscal drag with a cut in interest rates.

THE BEST CLUE to the economy's health is the outlook for consumer spending, especially during the crucial holiday season. Thanks to decent, if slower, growth in jobs and incomes this year vs. last, consumers have the resources to lift their purchases of goods and services this quarter close to the 3% to 3 1/2% annual rate likely hit in the third quarter. But while shoppers will enjoy the holiday season, profit-starved retailers may not share in the good cheer amid the need to discount.

Retail sales were in good shape in September. Total receipts rose 0.3%, and excluding weak car buying, sales were up 0.7%. In fact, except for car dealers and restaurants, all the major categories posted solid sales gains last month.

For the third quarter, real retail sales grew at a 4% annual rate, thanks to strong car buying earlier in the summer. Nonauto receipts rose at a 2% rate. While respectable, the pace was below the 2.9% gain in the spring (chart). And it came at a cost to retailers.

That's because consumers required price cuts to crack open their wallets, and those sales promotions are ruining retailers' profits. Heavy discounting forced Kmart Corp. to report that its third-quarter profits will be below year-ago levels--leading to speculation that the retailer would file for bankruptcy. Chrysler Corp. had to boost its rebates by a huge $350 per vehicle. That was partly responsible for the 46% plunge in Chrysler's earnings.

Discounting is a key reason for low inflation. In September, consumer prices inched up 0.1%. Excluding food and energy, core prices increased just 0.2%. Producer prices of finished goods rose 0.3% last month--the first gain since May--while core producer prices rose 0.2%. Consumer inflation is on track to end the year below 3%. If so, 1995 would be the fourth straight year of sub-3% inflation; 1996 may well be the fifth.

Consumer prices for goods alone edged up at an annual rate of just 0.6% in the third quarter, and they fell excluding food. As usual, the bargain hunting will grow even more intense during the holiday season. So retailers will struggle to maintain profit margins, and inflation will remain inconsequential.

Low inflation coupled with faster growth in nominal wages means that real hourly pay is finally increasing. This gain in purchasing power, evident in the third quarter's solid advance in real aftertax income, is another reason to expect consumer demand to hold up.

FOREIGN DEMAND looks buoyant as well. Exports of goods and services in August jumped 3.7% to a record $65.7 billion, led by autos, aircraft, and high-tech equipment. Because imports were flat, the trade deficit shrank sharply, from $11.2 billion to $8.8 billion, the smallest gap of the year.

The August improvement implies that net trade was much less of a drag on third-quarter economic growth than had been anticipated. The month's surge in exports suggests that U.S. manufacturers are benefitting from better growth abroad.

Steady growth in overall demand will support a continued pickup in industrial production in the fourth quarter. Industrial output fell 0.2% in September, but the decline mainly reflected a steep 5.4% plunge in utility output after the summer's hot weather boosted output to an unusually high level.

In the manufacturing sector alone, September output rose 0.2%, following a strong 0.9% advance in August. Those gains were the first since January.

Manufacturing output rose at an annual rate of 2.5% last quarter, after a second-quarter drop, but hours worked in the factory sector fell 2.7%. That combination suggests another excellent quarterly gain in factory productivity that will restrain unit labor costs and lift profits. BUSINESS WEEK'S early-bird tally shows overall corporate profits up last quarter but at a slower pace than in the first half.

LEADING THE OUTPUT PICKUP: consumer durables, business equipment, and construction supplies. Cars and trucks strengthened, as did home-related durables. Business equipment is fueled by information processing, with computer and office items up 26.9%. Better housing demand is lifting construction supplies.

The production rebound is a sign that businesses have cleared out most of their excess inventories that had cropped up earlier in the year. Inventory growth in manufacturing, wholesaling, and retailing has been slowing steadily all year, and stock levels rose 0.4% in August. And because of a strong 1.5% increase in business sales, the ratio of stocks to sales fell sharply. Manufacturing inventories, about half the total, didn't rise at all for the first time in a year.

One disturbing sign was a sharp 1% increase in retail inventories in August (chart). However, that rise was concentrated in furniture, building materials, and food, areas where the buildups were probably intended, especially in light of the strength in housing demand. With excess inventories about gone, the way is clear for further output gains--and continued expansion.

Of course, the longer you try to balance growth and inflation, the harder it is to maintain equilibrium. The danger is that the expansion could pick up steam and barrel through 1996, stoking price pressures. Or conversely, the worrisome buildup in consumer credit and big cuts in government spending could send the economy into a tailspin. For now though, steady noninflationary growth is the best bet.