Interest Rates Stirring Fears of a Recession

To hear most economists tell it, the end is near. After more than six years of unusually steady and sustained growth, a growing swarm of analysts now expect the economy to fall into a recession later this year or early in 1990.

But not so fast. Despite all the danger signs--the Federal Reserve has pushed short-term interest rates above long-term rates and consumer spending is slowing--there is also plenty of compelling evidence that the economy will continue to expand for another couple of years or so.

“I’m getting a little nervous about the Fed, but there’s still nothing in the data that suggests recession,” says Alan K. Reynolds, a conservative supply-side analyst at Polyconomics Inc.

Sees Continued Growth

And David Levine, one of the few forecasters who predicted in 1982 that the current expansion would last as long as it has, is convinced that the economy will keep growing at least through the end of 1990.

“As a prelude to a recession, you really have to have everyone convinced that inflation is completely unsatisfactory,” says Levine, of the respected New York investment firm Sanford C. Bernstein & Co. “That hasn’t happened yet. And even then it would take almost a year before a serious Fed tightening led to a downturn.”

Most economists, however, have joined the recession camp. Nearly 60% of the 54 analysts surveyed for the consensus Blue Chip economic forecast now predict a downturn either this year or next.

Typical is the comment of Richard Rahn, chief economist of the U.S. Chamber of Commerce. “The Fed is overreacting in raising interest rates,” he says, “and will inadvertently put us into a recession.”

John Makin, the American Enterprise Institute’s top domestic economist, is even more emphatic. “I’m convinced we’re going to enter a recession sometime in the second half of 1989. The die is already cast,” he says.

At stake is far more than bragging rights for economic forecasters. For millions of Americans, recessions spell layoffs and poverty. And, for the Bush Administration, a recession now would wreck its hopes of trimming the federal budget deficit and avoiding even more failures among savings and loan associations.

Administration officials are not only counting on robust growth over the next four years. They are also hoping that inflation will evaporate in response to federal spending restraint so that interest rates can fall dramatically. That is probably too much to expect.

Inflation is the danger. As Fed Chairman Alan Greenspan warned last month, once inflation begins to climb, “it’s just such an acceleration that could feed the kind of imbalances that ultimately bring expansions to an end.”

President Bush repeatedly has questioned whether the Fed is overreacting to the threat of inflation. And six conservative Republican senators complained last week to the White House that any further moves by the Fed to drive up interest rates will “sow the seeds of recession.”

In a letter, the senators urged Bush “to turn this situation around. . . . This over-tightening threatens the economic expansion and your effort to reduce the federal budget deficit without tax increases.”

There are some good reasons, however, to doubt the widely accepted view among analysts that the Fed has pushed interest rates so high that the economy is standing on the verge of a downturn.

Many of those who predict a recession in 1989 or 1990 depend on the far from reliable theory that changes in the money supply are soon followed by corresponding fluctuations in economic activity and later by a similar shift in the inflation rate.

Over the last two years, the most widely followed measure of the money supply--the amount of money available in cash, checking accounts and certain types of savings accounts--has grown very slowly. That has led many analysts to forecast an economic contraction or at least a sharp slowdown.

But the same theory failed earlier in this decade when its adherents mistakenly forecast sharp increases in inflation because the money supply was growing rapidly. There is no evidence the money supply is any more reliable today in predicting the course of the economy than it was a few years ago.

Rising interest rates are a second indicator that a recession is likely by the end of next year. Many economists are convinced that the increase--more than 3 percentage points in short-term interest rates over the last year--will force consumers to cut back sharply on spending, particularly because it will hurt homeowners with adjustable-rate mortgages.

But another school of analysts argues that such increases in interest rates, while they will squeeze some younger, middle-income families, might not put much of a dent in overall personal spending.

For one thing, nearly all adjustable-rate mortgages are capped so interest rates cannot rise more than 2 percentage points in any year.

Even if all holders of the estimated $800 billion in floating-rate mortgages were forced to fork over the maximum in higher monthly payments, the after-tax impact on consumer purchasing power would be only about $12 billion this year, says David Hale, chief economist at Kemper Financial Services in Chicago. That represents less than half of 1% of Americans’ disposable personal income.

Moreover, many Americans--those with such financial assets as certificates of deposit and money-market funds--actually benefit from higher interest rates. A 2-percentage-point rise in short-term interest rates would add about $20 billion to after-tax income, analysts estimate. Although rising interest rates shift more income to families that are older, wealthier and less likely to spend, there is little reason to doubt that their higher spending would largely offset the modest drag from higher adjustable-rate mortgages.

Of all the changes in the U.S. economy over the last decade, perhaps the one that will have the most impact on the timing of the next recession is deregulation of the nation’s financial system.

Before 1978, banks and savings and loan associations lost deposits when market interest rates moved even slightly above the government-imposed ceiling on the rates they could offer their depositors. And when S&Ls; lost deposits, the housing industry collapsed because its source of funds dried up.

In 1978, banks and savings institutions won the right to offer floating interest rates. Now they can pay whatever the market demands for funds and housing loans are available as long as borrowers are willing to pay the price.

“You aren’t likely to face a recession until housing plunges,” Hale said. “And because of deregulation, the interest-rate increases required to bring on a recession have become much larger.”

But just because a recession may still be well over the horizon, don’t count it out. Ultimately, the Federal Reserve’s efforts to slow the economy fairly painlessly in hope of curbing inflation are almost certainly doomed to failure.

“Much as they may hope for it, inflation won’t unwind until the Fed imposes serious restraint on the economy,” Levine says. Once unemployment falls far enough that employers must ratchet up wages to get workers, he argues, that the Fed’s predicament becomes practically hopeless.

“Policy-makers are loath to engineer recession until inflation has become a palpable problem,” he wrote in a recent report. “By then, by definition, it is too late to have prevented an inflationary upsurge. If this seems like a ‘Catch-22,’ it is because it is.”

And if that’s right, Bush could be in a more trouble than the character Yossarian in Joseph Heller’s novel, “Catch-22.” Under such a scenario, the economy would probably begin to falter some time in 1991. Like former President Jimmy Carter, Bush’s recession would arrive at the worst time for him--as the next presidential reelection season is getting under way.