For Once, the Best of Both Worlds
The current economic expansion is just entering its fourth year of uninterrupted growth. By most measures, this has been an utterly conventional recovery, despite the presence of a gigantic federal budget deficit, a record-busting trade deficit and unusually high interest rates in inflation-adjusted terms.
I realize that to some it hasn’t felt like a normal recovery in the past year or so, but that’s because so much of final consumer demand was being met by imports rather than by domestically produced goods and services.
Looking at GNP growth in the three years since the recession trough in the fourth quarter of 1982, we find that it has been just as strong as it was during the long and robust 1975-79 expansion and somewhat above the path struck by the typical postwar recovery at the same three-year milestone. Indeed, the typical recovery was all over by then. Only twice before, in 1975-79 and 1961-69, did we manage to keep a business expansion going for more than about three years.
If past is prologue, then, the U.S. economy should now be about ready to roll over into recession.
One of the primary factors contributing to the demise of an economic expansion has been a progressive tightening of monetary policy as evidenced by a cutback in money growth. Traditionally, this switch in policy has gotten under way near the end of the third year of recovery. We already have arrived at the moment of truth, the traditional inflection point for monetary policy.
No Excess Demand
But the past may not be prologue this time around. In the past, the economy typically began to develop problems of excess demand and accelerating wage and price inflation at about this stage of expansion, forcing the Federal Reserve to begin tightening down on money growth. There is no evidence of either problem at this time.
If anything, the opposite is true: The world suffers from an insufficiency of demand for almost everything, including oil and most other basic commodities. While the U.S. business expansion has been normal, the demand for domestically produced goods has been somewhat weak. There is plenty of unused capacity in the American economic system, and the ability to raise prices freely is practically non-existent.
Economic conditions worldwide are closer to those nearer the beginning of an expansion than at the end. Finally, the recent sharp decline in oil prices is an extra bonus that can hold down the rate of inflation while promoting economic growth in the oil importing countries.
Moreover, for a host of reasons, not the least of which is a deep concern about the financial viability of many farmers, financial institutions and even countries, it would be untoward for the Federal Reserve to allow financial conditions to tighten and interest rates to rise at this time. At the same time, the surprising drop in oil prices places in jeopardy yet another batch of bank loans, adding to the agricultural and less-developed-country loans already in doubtful status.
With capital investment having grown strangely weak, housing activity just beginning to show signs of revival and inflation remaining very quiet, the Federal Reserve itself recently may have switched its concern away from inflation toward growth and employment. Certainly, it is being urged to think that way by the Administration, which would like to see interest rates low and the economy rising smartly going into the critical autumn midterm congressional elections. Without a strong economy, the Republicans are very likely to lose control of the Senate and suffer a significant erosion in the number of seats they hold in the House of Representatives.
Besides, the Federal Reserve’s support of last September’s Group of Five decision to intervene in the currency markets and push down the dollar severely limits its ability to tighten domestic monetary policy or raise interest rates.
Threat of Higher U.S. Interest Rates
If other nations are expected to stimulate their domestic economies in an effort to take upward pressure off the dollar, they must do it in part by lowering interest rates. They can’t cut interest rates and keep their currencies strong at the same time unless U.S. interest rates are kept low as well. A rise in U.S. rates now would threaten to scuttle the entire intervention effort and perhaps send the dollar off on a new upward spiral.
Finally, there is the specter of Gramm-Rudman looming ahead. While no one expects the Congress and the President actually to cut everything they are supposed to cut under that law, there is little doubt that fiscal profligacy in this country is nearing the end of its rope.
To the extent that the federal budget deficit is legitimately and significantly reduced in coming months, it would be extremely awkward to have such actions accompanied by tightening monetary policy and rising interest rates. Besides, Chairman Paul A. Volcker has said many times that genuine budget reform would permit more flexibility for monetary policy, enabling it to offset through easier money the restrictive effects of deficit reduction.
Thus, not only do economic conditions call for the continuation of fairly liberal monetary policy, but other factors (not the least of which is the presence of an unusually high level of risk in the financial system) seem to require it as well. It is therefore quite likely that strong money growth will continue for several months to come, regardless whether the monetary targets are exceeded.
That being the case, past is not prologue this time around and there is only the smallest chance of recession anytime soon. The more likely prospect is a fourth year of continuing, perhaps even accelerating, expansion without a major increase in interest rates until late in the year, if then.
If that strikes you as being the best of both worlds, it is--for the time being.
