The U.S. economy will expand at a steady and moderate pace in 1994 with virtually no change in inflation, putting the recovery on solid footing after a long period of fits and starts.
According to the The Bond Buyer's annual survey of 30 economists, the Federal Reserve will begin tightening monetary policy in 1994, ending a period of gradual easing of short-term rates that dates back to 1989. The only debate centers on when Fed officials will begin to move and how aggressively they will try to keep inflation in check.
Bond rates are not expected to move much next year as consumer price inflation rises marginally to 3%. That would compare with the 2.8% some analysts expect to see this year and the 2.9% recorded in 1992.
"It will be a year of transition," said Joseph Liro, chief economist for S.G. Warburg & Co. "The roller coaster ride is over, where we have these spurts and dips. Statistically, it's going to look about the same, but it should feel better. We're in for a period where we just plow straight ahead and get fairly consistent growth."
The Clinton Administration is counting on steady growth and low interest rates to bring down the unemployment rate, fuel business investment, and narrow the federal budget deficit. Administration officials have signaled that they expect growth of 3% next year, nearly the same as the 2.9% average gain of those, surveyed by The Bond Buyer.
One striking feature of the survey is the narrow range of estimates, not only for gross domestic product but for the consumer price index, short-term rates, and long rates. For example, 21 economists, or two-thirds of those surveyed, offered estimates of CPI between 2.7% to 3.3%.
In addition, those surveyed said they do not expect average growth to vary much during the first and second half of the year.
"The consensus is remarkably fight," said Neal Soss, chief economist for CS First Boston. "There isn't enough strength in the economy in the broadest sense to give a real cyclical pickup here, so there's no boom, but at these levels of interest rates that have been achieved, there's no reason to fear a bust."
There is also widespread agreement that the hot economic statistics that have been churned out by the government for the closing three months of 1993 will not be repeated. Those surveyed said they expect fourth-quarter GDP to hit 4.2%, but growth in the first quarter of 1994 is expected to slow to 3% - a respected performance, and more in line with the pace anticipated for the year as a whole.
No Cakewalk
However, even though many of the economists came up with similar numbers for the year as a whole, they have their differences and caution that the bond market will not be a cakewalk. "The reality of 3%-plus growth creates some problems," in terms of stirring inflationary pressures, says Michael Strauss, chief economist for Yamaichi International (America) Inc. "Now we're seeing signs of stronger growth. We're jumping from fourth gear to fifth gear."
In fact, the outlook from most analysts next year seems to hinge on the extent to which the economy pulls back to a more sedate pace from the gangbuster close to 1993. It is the opposite pattern of the recent past, when the debate centered on when the wobbly recovery would get its sea legs.
Not all those surveyed are optimistic about the economic outlook. Philip Braverman, chief economist for DKB Securities Inc., said he believes the growth spurt of the last six months was due to special factors, such as rebuilding from the Midwest floods and a credit card binge by consumers.
"We're in a global syndrome of downsizing and layoffs," said Braverman, who sees no Fed tightening and expects the yield on the long bond to drop to 5.40% by yearend.
For most economists, however, the pattern of growth next year will be largely set by trends that emerged with clarity during 1993.
Consumer spending, which accounts for two-thirds of GDP boomed as buyers snapped up automobiles and other durable goods to close out 1993. The spending pace, though, is not expected to be sustained because consumers drew down on savings while gains in employment and income were modest. Still, analysts expect the jobless rate to fall to nearly 6% by the end of next year.
Analysts also expect the residential sector to keep expanding as home buyers take advantage of low interest rates. But again, housing is not expected to grow as much as it did this Year, when starts of single-family homes surged to 1.43 million units, the highest level in nearly four years.
Another sector that has fueled growth, business spending on plant and equipment, is expected to do so again in 1994, but not as much as this Year. The Commerce Department reported that businesses plan to boost capital spending by 5.4% in 1994, down from 7% this year.
Lack of ~Lift'
"The strong sectors will remain strong, they just won't have the lift they had," Liro said.
Meanwhile, other sectors of the economy are expected to remain weak. Federal outlays are being held in check by a tight fiscal policy, with defense downsizing continuing on schedule as bases are closed and military contracts dry up.
A widening trade gap is likely to continue to act as a drag on growth for most of next year because Japan and Europe show no signs of climbing out of recession. A recent report by the Paris-based Organization for Economic Cooperation and Development says joblessness in Europe will climb this year, and Japan's efforts to stimulate domestic demand were criticized last week by Treasury Secretary Lloyd Bentsen as inadequate.
Steady economic growth next year will be good news for the average consumer and bad news for the bond market. Most of those surveyed believe steady growth in the national economy will put upward pressure on inflation and interest rates.
It's clear from the survey results that the discussion has moved from whether the Fed will boost short-term rates in 1994 to when it will. Few economists doubt that the central bank will want to keep inflation in check next year.
Twenty-five of those surveyed expect a tightening of monetary policy in the first half of 1994, and 27 are looking for another tightening by the end of the year. Respondents generally believe that the Fed will raise its federal funds rate target by about 25 basis points in the first and second halves of 1994.
"I believe the economy has turned the corner and that we've seen the end of the disinflationary trend," said Stephen Gallagher, senior economist at Kidder, Peabody & Co. "Rates will move higher because the expansion will continue and because we'll see slightly higher inflation numbers."
Expectations for higher short-term rates are predicated primarily on the belief that continued growth in the U.S. economy will result in higher prices - a development that is likely to prompt the Fed to tighten credit. Economists surveyed on average look for the consumer price index to reach 2.9%, marginally higher than the 2.8% inflation level apparently achieved in 1993.
Fed Is ~Uneasy'
The only point of contention is how soon the move will come. Wall Street observers remain mixed on whether the Fed will wait until inflation picks up before it tightens credit or boost rates preemptively to head off price pressures before they appear.
Robert Brusca, chief economist at Nikko Securities Co., believes the Fed is already "uneasy" about leaving the federal funds rate so low for so long. He said the central bank wants inflation reduced to below 2%, and with the underlying inflation rate stuck at 3% - a full percentage point above its wishes - the Fed should be viewed as biding its time.
"The Fed will be disappointed to see inflation is not falling toward 2% and I think they will raise rates at the end of the first quarter," Brusca said.
If the downward trend in oil prices reverses, Brusca said the central bank will certainly raise rates, noting that the Fed views the drop in oil prices as temporary and will be willing to tighten as soon as it is politically expedient. Short-term rates will move higher "as soon as it becomes accepted that the economy is in no risk of backsliding," he said. "We are close to that point."
Not all economists view inflation as a threat. David Resler, chief economist at Nomura Securities International, said that the economy "faces a protracted period of respectable but unexciting growth." He said that unless growth accelerates more dramatically than economists now predict, it will be years before the economy encounters the kind of production bottlenecks that have, in the past, been associated with rising inflation.
"We calculate that even at a steady growth rate of 3% per year, the economy would not begin to encounter the limits of capacity until sometime in 1998," Resler said.
Others think the Fed will move next year simply to remind the financial markets that it stands firmly by its directive to control price pressures on the national level and to officially signal the end of the interest rate cycle.
"The Fed may decide to tighten early in 1994 simply to show their resolve on inflation," said Mickey Levy, chief economist at Nations-Banc Capital Markets Inc. "The bond market is groping with stronger economic growth and wondering what it will do to inflation. The Fed may want to send a signal that it means business on getting prices lower."
Ironically, forecasts for slightly higher inflation growth have not translated into expectations for a spike in long-term interest rates. Most economists polled agree that the yield on the 30-year Treasury bond will remain confined to current ranges. While forecasts for long-term rates run the gamut in the latest survey, Wall Street economists on average think the benchmark bond will yield 6.21% at midyear and 6.32% at yearend.
Facing Challenges
The challenges facing fixed-income investors in such an environment are risk management and positioning. Given widespread expectations of decent economic growth in 1994 and higher interest rates, market participants are less than enthusiastic about owning long-dated Treasury paper. With short-term rates poised to move higher, conventional wisdom suggests that investors buy intermediate securities to protect their holdings from potential volatility at either end of the yield curve.
"The bond market has priced in most of the good news on inflation," said Steven Ricchiuto, chief financial economist for Barclays de Zoete Wedd. "Higher inflation will prompt people to rethink their views and strategies on the market."
Ricchiuto expects inflationary pressures to build as the year unfolds, pushing the CPI to 3.5% in the final quarter.
Others are more optimistic about the bond market's potential next year, noting that yields will gyrate but end the year on a positive note. S.G. Warburg's Liro said he expects the economy to slow gradually during the year, but not before inflationary worries push the yield on the long bond as high as 6.70% in the spring. Still, by yearend he is forecasting bonds will fall back to 5.70% as investors regain confidence that inflation is under control.
"The longer we can maintain a relatively stable inflation rate of somewhere around 3%, the more that inflation premium that is already built into the bond will be squeezed out, and you can get the bond coming right back down," Liro said.
While observers point to a number of factors that will affect growth, they generally agree that the economy's performance next year will be closely tied to the cost of money, as prescribed by the Fed's interest rate policy.
Many economists agree that the housing sector will be one of the best barometers of the economy's future health. As market analysts sat down to construct their final economic forecasts for 1994, many said they scrutinized housing statistics to gauge whether demand will march into the new year or fall by the wayside.
"The interest-rate sensitive areas of the economy are the ones to watch next year," said Brian Wesbury, chief economist at Griffin, Kubik, Stephens & Thompson Inc. "Housing and autos were powerful engines of growth in 1993 and it's important for the economy that those sectors remain strong."
But as 1994 approaches, the question is whether higher interest rates will hamper the housing sector's performance, as well as the overall economy"s.
