The economic expansion is mature but has survived its midlife crisis.
It paused in the first half of 1995, especially the second quarter, for some adjustments in inventories, housing, and consumer spending.
Now, virtually all the data indicate renewed vigor. Indeed, the pattern is typical of the early stage of a recovery, with housing and consumer spending leading the way.
In our view the inventory adjustment is more than two-thirds complete and the burden of unsold houses has been significantly reduced. This should pave the way for further consumer spending for household goods and a reacceleration of industrial production. Meanwhile, capital spending continues to grow rapidly.
By the fourth quarter, all the negatives apparent earlier will have reversed to positives. From this point looking forward, there appears to be no impediment to sustained growth. In other words, the expansion appears to have a long life still ahead of it.
An important contributor to this balance has been muted inflation.
While there are still some cyclical price increases, it appears that they are well contained and are not becoming embedded into the price structure. Moreover, long-term social and economic trends are effectively suppressing cost pressures throughout the economy.
The most significant of these is the employment cost index. This series continues to moderate. It rose a mere 0.7% in the second quarter and 2.9% from a year earlier. Major collective bargaining settlements in the second quarter rose by even less, also a continuation of a trend. In fact, life- of-contract wage and benefit increases in the second quarter averaged 1.8%; over the last year they were 1.1%.
Analyzing the employment cost index and collective bargaining settlements together, it is clear that unions are losing power at a quickening pace, thereby holding down labor costs, which account for 60% to 70% of the cost structure in the economy.
But labor costs are not the only element in diminishing inflation. Corporate restructuring has also contributed. Restructuring encompasses more than simply reducing the labor force. American business has invested heavily in efficient and highly productive equipment, has exploited new technologies, has reengineered production procedures and has improved the quality of products and performance. As a result, profits have grown rapidly and are likely to continue to do so.
Good profits lead to further capital spending, more efficiency and productivity, and so on - a virtuous cycle.
Also contributing to the diminution of inflation, in our view, has been the shift of resources within the economy from defense spending to private- sector spending.
It is obvious that in a capitalist system, private-sector spending for private-sector use will lead to a more efficient economy than government spending for items that we hope would never have to be used. Profits drive a capitalist economy. They are a reward for entrepreneurship. With good profits continuing and inflation suppressed, the expansion can continue indefinitely.
Holding down inflation is crucial because inflation erodes incomes, leads to high interest rates and tight money, and eventually causes a boom- bust scenario.
The risks are at the policymaking level. Monetary policy has been especially adroit over the past couple of years. We believe the Federal Reserve will continue to manage its responsibilities well, tightening if the economy overheats and easing when economic and inflation conditions warrant.
Fiscal policy is another matter. The entire fiscal picture has become clouded by increasingly nasty partisan politics. The danger is that deficit reduction could be jeopardized or mismanaged.
Since interest rates declined after the 1992 election in anticipation of deficit reduction and again after the 1994 election in anticipation of further deficit reduction, it follows that a failure of the federal government to meet expectations would result in disappointment and rising interest rates. In our view, that's the biggest threat to the expansion.
Tax reform is separate. We are encouraged by the evolving attitude that the tax structure needs to be revised to provide greater incentives for saving and investment. But tax reform will probably have to wait until after the 1996 election.
Meanwhile, the economy and inflation are unusually well balanced, and the outlook is favorable.