Outlook for ‘87: More of the Same

Confounding pessimists who had written it off as early as two years ago, the current economic expansion has achieved another milestone--its fourth birthday. As a result, it has moved into third place in terms of post-World War II longevity, trailing only the 106-month expansion of the Vietnam War period and the 58-month expansion of the latter half of the 1970s.

It has been a most interesting recovery, because it is strong in some dimensions and weak in others. Perhaps this “split personality” is what has led some analysts to predict a recession though none has occurred and others to project a boom, with similar results.

Looking at the output statistics alone, it would appear that this expansion has been weaker than average. As against a 21% gain in the gross national product (adjusted for inflation) for all recoveries that lasted this long, the current upswing has registered little more than a 16% rise in real GNP.

However, it is not because of lack of spending. Real domestic demand has risen 22.2% during the current expansion, compared to 21.9%, on average, for the others. The difference stems largely from foreign trade. Real exports have grown only 11% in the past four years, less than half the 24.3% average rise that took place in past 48-month upswings. By contrast, real imports have shot up nearly 66%--almost twice the 33.8% average rise of previous expansions.

The sluggishness in the output side of the economy has helped drive inflation lower. We have made much more progress in reducing the rate of inflation this time around than we did on average in the past--or, for that matter, in any single postwar expansion. Usually, the inflation rate accelerates when the economy grows. The fact that inflation was reduced at a time when the money supply has grown much faster than it ever has makes this development even more remarkable.

However, the surge in money growth appears to have helped push up stock prices. The Dow Jones industrial average has jumped 76.5% over the past four years--more than three times its average rise and 1 1/2 times greater than the next largest increase, which occurred during the 1954-57 expansion.

Another Birthday Likely

What, then, do all these comparisons mean for 1987? Will this expansion live to celebrate its fifth birthday, becoming the longest peacetime expansion in the postwar era? The answer would appear to be “yes”--notwithstanding the existence of more than the usual number of uncertainties.

The fact that this expansion has lasted four years is, itself, an uncertainty, since it is already 14 months longer than the average peacetime expansion. The fact that we have had so many recessions--not just in the postwar era, but stretching back into the early part of the 19th Century--would seem to suggest that, sooner or later, this expansion, too, will come to a halt.

The trade deficit is another uncertainty. Driving a wedge between consumption and production, the trade deficit may have peaked, but it is not clear how rapidly it will diminish, since the dollar is not as weak as is generally supposed. And if the trade deficit remains large and the goods-producing sector stays weak, there may come a point when this weakness will spill over and begin to affect sectors that remain strong, notably services, construction and consumer spending.

Besides these economic uncertainties, two political uncertainties cloud the outlook.

The first is tax reform--a major restructuring of the nation’s tax system. It has already produced significant cuts in business spending owing to the removal of the investment tax credit and changes in depreciation allowances. It is no doubt affecting consumer spending right now, since sales tax deductions will be eliminated for items purchased after Dec. 31. Until people can determine whether they will come out ahead or behind, they are likely to spend cautiously, producing a further drag on economic activity.

The second political uncertainty is the Gramm-Rudman Deficit Reduction Act, which mandates yearly cuts in the U.S. budget deficit until balance is achieved in 1991. The problem is that the target for fiscal year 1986, which ended Sept. 30, was overshot by a wide margin, as the budget deficit came in at $220 billion.

In view of this, it does not seem likely that the target for the current fiscal year, a deficit of $144 billion with a $10 billion leeway, will be met.

The uncertainty deals with just exactly how much the deficit will be brought down. If the Administration and Congress cut the deficit too much, it could pull the economy down into a recession. But if they don’t cut the deficit enough, it could cause a significant backup in interest rates, which would also bode ill for the business outlook.

Having said all this, our forecast for 1987 calls for continued growth with no recession in sight. The year as a whole may log in the same average growth rate as 1986 and 1985, with results strengthening after softness early in the year.

We base this moderately optimistic outlook on the absence of pre-recession signals along with the presence of pro-growth signs.

Developments that have tended to occur immediately before past recessions are nowhere in sight:

- The economy is not overheating. There is enough idle capacity, unemployed workers and supplies of commodities to keep the economy’s temperature, in the form of the inflation rate, moderate.

- The Federal Reserve is not tightening credit. Interest rates have declined over the past year, with short-term rates well below long-term yields, while the supply of money and credit is growing rapidly. If anything, the Fed may ease another notch before long.

- Fiscal policy is not restrictive.

- Consumer demand is not contracting. In the first nine months of this year, real personal consumption outlays climbed by a healthy 5.6%--with a 7.2% leap in the third quarter.

- The stock market is not falling. Equities, as measured by the Dow Jones industrial average, have been trading in a relatively narrow range for the past half-year, keeping both business and consumer confidence at high levels.

Besides the absence of negatives, consider the existence of several positive developments.

- Lower oil prices, which, although causing severe cutbacks in spending by oil companies, have boosted the buying power of both business and consumers by lowering a wide variety of costs.

- Lower interest rates, which may have reduced the interest income of those who save, but have also cut costs of those who borrow.

- The lower dollar, which, although not down everywhere, has fallen sufficiently against the currencies of enough countries to stop the growth in our trade deficit, thus curbing the drain on output it represents.

- The jump in employment, which has produced record numbers of people with jobs, thus adding to buying power--not to mention bolstered confidence.

- Higher stock and bond prices, which have enhanced the purchasing power of those owning these instruments, as well as the attitudes of many others.

Along with continued growth in the economy will come a pickup in the rate of inflation. However, considering the fact that prices at the consumer level declined during the second quarter of this year, while at the producer or wholesale level they remain below year-ago levels, one should not be overly concerned that this represents the first step on the road toward overheating.

Whatever increase we do experience in the rate of inflation will have little to do with the pace of expansion, since there is plenty of slack in the economy in the form of idle workers, excess capacity and surplus commodities.

We expect the financial markets to take their cue from the economy and exhibit a split personality as well. Short-term, or money-market, rates should do no more than hold steady for a while with the distinct possibility that they might move lower. The Fed might be tempted to push short rates down to obtain a bit of insurance that the economy will continue to grow and at the same time keep the dollar under pressure in order to boost our exports while retarding the inflow of imports.

On the other hand, long-term or bond-market rates may hold steady with an upward tendency. This would reflect the belief on the part of participants in the long end of the markets that deflation is a thing of the past and that the rate of inflation is expected to rise.

In conclusion, the best bet is that the economic expansion will continue and that a year from now the birthday cake will have one more candle on it.