SAN FRANCISCO -- Gary Schlossberg is an economic bull - with an asterisk.
A senior economist at Wells Fargo & Co., Mr. Schlossberg says the U.S. is making a transition from recovery to moderate growth.
But asked if he is bullish, Mr. Schlossberg offers a qualified response. "If you mean continuing to grow at a moderate rate, certainly bullish," he said.
"If you mean growth like we had in the 1980s, I am moderately bullish."
Mr. Schlossberg predicts inflation will climb to the 4% range and the federal funds rate will peak at 7.5% over the next couple of years.
For banks, he sees a challenging future. Flush with liquidity thanks to a steep yield curve, he said, banks will slowly find more demand - and competition - for loans as business has greater need for outside capital.
Mr. Schlossberg says the economy in Wells Fargo's home state of California probably will lag behind the national economy throughout the decade as military base closings continue. Outside factors that could slow the Golden State's turnaround include higher interest rates and the threat of higher federal taxes
In an interview, the 46-year-old Brooklyn native offered these views:
Q.: Where do you see the national economy at this point?
SCHLOSSBERG: A year ago we fizzled out after a strong fourth quarter in 1992, then we bounced back late last year and everybody was talking about a boom. Many of us realized that given some of the lingering weaknesses in the economy and just the normal patterns of the business cycle, you normally get a big burst of growth shifting toward a more moderate sustainable rate.
That seems logical. Pent up demand is released so you get the big burst, that dissipates; then consumer spending shifts gears and we're seeing some of that now; and businesses swing from liquidating to building inventories and that adds to the strength.
Q.: Is this in line with historical patterns?
SCHLOSSBERG: I think so, only now we are into what seems to be the second quarter of more moderate growht. My guess is that the average over the next year will be closer to 3% or so, rather than to the kind of 7% growth rates we've had.
Q.: How long do you expect the moderate growth to continue?
SCHLOSSBERG: You have to look at the business cycle and what normally comes into play. The normal peacetime recovery is about 36 months at least back through the 1940s. This one was slower to develop.
My guess is it will remain fairly moderate and the pressures, the bottlenecks that build up will be slower to develop. So I would think this expansion - and we are completing the transition from recovery to business expansion - has at least another 18 months to run. It may be longer than that.
Q.: What could shorten that estimate?
SCHLOSSBERG: Well, there are the usual surprises. If food prices or oil prices continue to rise, that squeezes purchasing power. More likely, inflation should build gradually but steadily, initially because of restoration of pricing power to businesses, and then you'll have wage inflation kicking in. What would really choke it off would be more aggressive tightening by the Federal Reserve.
Q.: How much higher can the Fed go without hurting the economy?
SCHLOSSBERG: It really depends. Our guess is that two years from now that inflation will be 4 to 4.5%, which incidentally is the average over the last 30 years.
At that point, as inflation is accelerating and we are late in the business expansion and the Fed is tightening more aggressively. ... I don't think it's inconceivable that the federal funds rate could be 7.5 to 8% before it's all
over.
We may be a little pessimistic, a little high on the inflation outlook, but I don't think it's inconceivable that two years down the road inflation would be [an inflation-adjusted] two percentage points higher than it is now. It seems to me that that would not be unreasonable between now and 1996 or, for [President Bill] Clinton's sake, 1997. Many of us think we are going to be more vulnerable to a recession as we progress through 1996.
Q.: Give me a regional snapshot of your economic outlook.
SCHLOSSBERG: We still have a continued weakness on the coasts. The Northeast is still ahead of California, with both recovering very slowly. The real strength is in the Rocky Mountain states. They are getting a good part of the migration out of California. The Midwest is benefiting from the revival of the manufacturing activity and should continue to benefit as those sales become increasingly export-oriented.
Q.: Is free trade going to make this post-recovery period different?
SCHLOSSBERG: It seems to me that foreign trade is really a double-edged sword and we are seeing some of the downside to it. Initially, you get a lot of foreign competition and we are seeing that. We have had some structural changes and pressures which I think we are beyond right now. There is pressure from foreign competition, which has forced businesses to cut costs, restrain wages and consolidate. The layoff announcements are higher now than they were a year ago.
Q.: Would that have happened without a free-trade agreement?
SCHLOSSBERG: Yes. I think the free-trade agreement will reinforce the more positive side of foreign trade over the next couple of years. Because it opens up new markets, the U.S. is clearly a net beneficiary. [Free trade] also gives us the opportunity in the services sectors to open up in new markets.
Q.: What does all this mean for banks?
SCHLOSSBERG: There are obviously opportunities in these overseas markets. As economies develop there is pressure to deregulate and with that pressure that opens up opportunities overseas. Before that, I think there are trade-related opportunities.
Q.: Domestically, what does this economy mean for bank lending?
SCHLOSSBERG: Banks today are liquid, but that is typical. Superimposed on this [economic] cycle, is an interest rate cycle and a bank credit cycle. We really did get a break from the steep yield curve. California benefited, perhaps more than Texas in the mid-1980s, from an unusually steep yield curve. It really facilitated the rebuilding of liquidity. If you want to call it a bailout of banks I think that's stretching it a little bit. I don't think the Fed had this game plan to help the banks by driving the funds rate down to 3%. It was done more to keep the economy moving.
Q.: So maybe the question is what they will do with that liquidity?
SCHLOSSBERG: Exactly. The next test is will they or won't they regain some of those traditional banking markets. In some cases the jury is still out. Certainly, there have been enough structural changes in corporate sector that banks were already losing market share. If you look at the numbers recently, C&I loan growth is coming back fairly nicely at a time when commercial paper activity is tapering off. I am not saying that businesses are replacing commercial paper with bank loans.
The more important thing is what's happening with C&I growth is that it's not very dramatic just yet. But you wouldn't expect it to be, because businesses are fairly liquid as well. We are getting into that stage of the cycle where businesses do have to meet financing needs with outside sources of funds. One indication of that is the pick up in short-term business borrowing, and banks are sharing in that recovery.
Q.: On California, you have said there is light at the end of the tunnel.
SCHLOSSBERG: I think we are closer to the light. Whether you want to call it a recovery or a bottoming out depends on how you define recovery. That fact is that employment has been moving up, barely, since December.
I think the recovery will be hurt more here by higher interest rates than in the rest of the country because home prices are about 65% to 70% higher. For example, we've had a 1.5% increase in mortgage rates since early February. For the medianpriced home in the U.S. that means that average monthly payments are up $90. For California it's more like $150.
Q.: What about the impact of any higher federal taxes?
SCHLOSSBERG: We've got about 16% of the households in the U.S. with incomes over $100,000 [annually]. So higher taxes will have a proportionally greater impact in California.
Q.: California benefited from the defense buildup, but now it is paying a high price for that. How will that affect the state's outlook?
SCHLOSSBERG: I think we are going to lag the U.S. at least through the mid-1990s. The problem is defense. You've got the aerospace layoffs tapering off, but you have the [military] base closings kicking in.
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