WASHINGTON -- The U.S. economy, which enjoyed the fastest growth in a decade in 1994, will probably slow to a more moderate pace in 1995 as higher interest rates finally sink in, according to 25 economists surveyed by The Bond Buyer.
These analysts from major banks and brokerage firms say that it is only a matter of time before businesses and consumers begin to feel the impact of the Federal Reserve's six increases in short-term rates in 1994. And they say additional credit-tightenings are in store during the first half of 1995.
"I'm confident the slowdown will occur. The Fed has been tightening and the economy has been going way faster than potential for a sustained period," said Mickey Levy, chief financial economist for NationsBank.
The forecasts for 1995 are based largely on what happened -- and what did not happen -- in 1994. While the economy purred along in high gear, inflation never showed up. Wage pressures remained muted, and U.S. productivity strengthened.
To the delight of the Clinton Administration, the economy also generated 3.1 million new jobs while the civilian jobless rate fell to 5.6%, the lowest level since the summer of 1990. Labor Department officials say that once the December employment gains are recorded, this year will probably show the largest gain in nonfarm payrolls since 1984.
Next year, growth is expected to be mild while inflation turns a little higher as consumers find themselves paying higher prices to companies beset by capacity restraints in labor and commodity markets. Overall, economists look for inflation of about 3.5%, a slight upturn after this year's tame increase of under 3%.
For the 12-month period ending in September, U.S. gross domestic product surged by nearly 4.5% -- far above the 2.5% pace that economists generally consider the speed limit for avoiding an upturn in inflation. All indications are that the economy continued to boom through the final three months of 1994, with GDP growth of 4% or higher.
In an economy that will soon be producing $7 trillion a year in goods and services, there appears to be plenty of momentum that will at least spill over into the early part of 1995 and lead the Fed to raise rates some more. Scattered reports from the Fed's district banks indicate rising prices for steel and other commodities along with scattered labor shortages that are starting to translate into higher wages.
But a milder pace of growth does seem to be in the cards. On average, the economists surveyed by The Bond Buyer estimated that GDP will slow to about 2.75% during the first half of 1995 and even lower -- to about 2.1% -- during the final six months. That kind of growth could prove to be a welcome boost for the bond market, confirming success for Fed officials in their effort to slow things down without sparking a recession.
"Once the slowdown begins there will be a bond market rally that will be larger in magnitude than people currently anticipate," said Levy.
Those surveyed said they expect the Fed to raise the federal funds rate, which is the rate banks charge each other for loans, to 6.75% by the end of June. That would be a full percentage point increase from the 5.75% rate set by the Federal Open Market Committee on Nov. 15.
However, moderating growth is expected to help lower rates slightly in the second half of the year. Those surveyed said they expect to see a federal funds rate of 6.5% on Dec. 31, 1995, implying a slight easing of credit conditions by the Fed as the year goes on.
"I don't think you can fine-tune this economy that closely, which means the Fed will be constantly adjusting the dials," said Darwin Beck, managing director at CS First Boston. "If it goes too far, I think the Fed will be fairly quick in easing monetary policy."
Long-term interest rates are also expected to crest and fall slightly as the year progresses. The economists said they are looking for a yield of 8.0% on the Treasury's 30-year bond on June 30, which would not be much of a change from where it has been recently. By Dec. 31, the forecast is for a long bond yield of 7.75%.
One key point in understanding this outlook is that changes in economic growth typically come slowly, as long as the economy is not plagued by large imbalances. In fact, this year's growth has been not only remarkably strong, but balanced.
Consumers have been spending heavily on everything from cars to computers, with the help of ample credit from banks and other lenders. Businesses, too, have been investing heavily in plant and equipment to stay competitive in a global marketplace. Easy credit in the form of adjustablerate mortgages has also helped insulate the housing industry from rising rates.
As demand increased, businesses built up inventories by unusually large amounts in anticipation of continuing sales. Economists figure that as much as one percentage point of the 4% growth in 1994 came from inventories.
In 1995, economists expect to see a softening of consumer demand that will lead businesses to build inventories at a slower pace, reducing GDP growth. Technically, GDP growth measures change in inventories, which means that, for example, if businesses add $60 billion to inventories one year and then only $30 billion the next, GDP is reduced by $30 billion.
In comments to the Chicago Board of Trade, Fed vice chairman Alan Blinder said he believes a slower pace of inventory-building by business will be a major factor in cooling the economy in 1995.
"Inventories are the least sexy subject to talk about in economics, but right now it's the most important," said Sung Won Sohn, chief economist for Norwest Corp., in Minneapolis.
Another main factor at work in this year's outlook is that changes in interest rates by the Fed can take up to a year to wash into the economy and influence behavior by business and consumers.
Furthermore, up until last spring, officials were still keeping short-term rates low. The first two rate increases by the Fed, in March and April, took the federal funds rate to 3.75% from 3.25% as officials held back from a more aggressive policy to avoid unsettling financial markets.
These and subsequent rate increases for 1994, ending with the Nov. 15 boost to 5.50% from 4.75%, will not be fully felt until this year. Home owners with adjustable-rate mortgages, for example, have loans that take a year or longer to reset. Meanwhile, a rising prime rate is now boosting borrowing costs for small businesses and home owners with home equity lines of credit.
Perhaps the one wild card in this year's outlook is political, rather than economic, with the Republican-controlled 104th Congress coming to power in what is shaping up to be a head-on fight with the White House over taxes and fiscal policy.
Most economists note that both Republicans and Democrats remain committed, in word at least, to keeping the deficit under control by paying for any tax cuts with spending cuts. In fact, the budget agreement of 1990 put into law a pay-as-you-go policy on tax cuts.
In addition, any changes in the federal budget are likely to be small and phased in over a period of time. For example, President Clinton's proposed middle-income tax cut would cost an estimated $60 billion over five years and would be paid for in large measure by extending caps on discretionary spending in 1999 and 2000.
Still, analysts fret that Congress and the White House could end up in a bidding war that would wreck the budget agreement and stimulate the economy at a time when Fed officials are seeking to keep a lid on things.
"Should any material fiscal stimulus package be passed, monetary policy will become more complicated for the Fed," said Charles Lieberman, managing director at Chemical Securities Inc., in a letter to clients.
Merrill Lynch analysts told clients: "A dose of fiscal stimulus is the last thing that the U.S. economy needs as it enters the fifth year of expansion. Tax cuts fully offset by spending cuts would be good for the economy. But tax cuts that blow a bigger hole in the budget will lead to higher interest rates and undermine the long-term performance of the economy."
David Lereah, chief economist for the Mortgage Bankers Association, said his forecast assumes the Fed pushes the federal funds rate to 7% by June but that no major changes arise from the Republican-led Congress.
"Gridlock may be a better outcome to 1995's budget debates than the other likely alternatives," said Merrill Lynch.
The main risk is that the economy will turn out to be even stronger than expected as exporters pick up business from a reviving Europe and Japan, said Lereah. Such a scenario would add to inflationary pressures and keep the bond market on edge.
But there is also a risk that the Fed will jack up rates too far, setting the stage for an economic downturn in 1996, analysts said.
Lynn Reaser, chief economist for First Interstate Bank, stressed that because of the lags in interest-rate changes and the impact on the economy, "the next six months will be critical to determining the outlook for 1996. Monetary policy actions taken during this time will set the stage for either slower growth or a recession in that year."
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