Inflation warning - for 1985
Despite all the talk about supply-side economics, traditional stop-and-go economic policy is alive and well in Washington. An anti-inflationary policy of restraint has been followed by a dose of economic stimulus. According to my foggy crystal ball, the current momentum of economic expansion - coupled with low inflation - should continue through 1984. The buildup in inflationary pressures, however, will exact its toll on economic policy - but that is likely to be a story for 1985.
The 1983 recovery, like all of its recent predecessors, is being fueled in its initial stage by the demands of the American consumer for new housing and for consumer goods and services. Housing starts have been rising rather steadily since early 1982. New starts are now running double the rate at the beginning of 1982.
This expansionary movement is likely to last for some time, especially because thrift institutions now have ample liquidity for making new mortgages.
In addition, three current developments are bolstering consumer spending:
1. Two tax cuts have increased consumer disposable income. The well-known 10 percent reduction in personal income tax rates was effective on July 1. But another one-shot event occurred in the form of unusually high refunds of prior income tax payments. For technical reasons, the Internal Revenue Service reduced the withholding rates only 8 percent in July 1982, when the tax rates were also decreased by 10 percent. Thus, many taxpayers who involuntarily overpaid during the course of 1982 received special refunds in the first half of 1983.
2. The rising stock and bond markets have increased consumer net worth by well over $500 billion during the past year. To be sure, these are paper profits , and consumers are not rushing out and cashing them all in. But this fundamental improvement in consumer balance sheets surely helps to explain why recent surveys of consumer sentiment point up so sharply.
3. Perhaps the most important factor making for stronger consumer outlays and a durable recovery is what I call Weidenbaum's cynical indicator. Congress has voted a ''jobs'' bill. That has often been a sign of continued economic growth. As it has done so often in the past, Capitol Hill waited until unemployment had already begun to decline and employment was on the rise before taking action to increase jobs. So-called jobs bills are the kind of quick fixes that usually come on stream after business has already turned up.
Nevertheless, we are not about to enter an economic Valhalla. There is no shortage of serious economic problems that continue to face us. These include chronic large budget deficits, high interest rates, rising trade deficits, slow recovery in basic industries, and historically high unemployment levels. Although most citizens do not think about them together, there is a strong linkage among these economic problems - starting with large deficits, which encourage high interest rates and a strong dollar, which in turn reduce the competitiveness of American industry. The resultant large trade deficits and continuing high unemployment exacerbate the pressures for restricting trade.
The presidential election campaign has already started. This means economic policy is now virtually on automatic pilot. New initiatives may be debated, but serious action likely will be deferred. Yet, in the next few years, budget deficits will be declining from the current level of $200 billion. But that will not be the result of any new policy actions. Rather, the reduction in the deficit will merely reflect the higher tax collections and lower unemployment payments that result from economic growth. Nevertheless, a painfully large chronic or ''structural'' deficit will remain substantially in excess of $100 billion. To talk of substantial tax increases before the election is mere posturing.
The key point to keep in mind is that neither the Congress nor the White House is paying more than lip service to reducing government spending. The tens of billions of dollars that have been cut from domestic social programs have been more than offset by expansions in defense procurement, farm subsidies, and interest payments. Federal outlays are now expanding more rapidly than the gross national product. In 1981, federal spending equaled 23 percent of GNP. This year the ratio is up to 25 percent.
The main economic actor is now the Fed. The Federal Reserve system currently is enjoying a period where it possesses considerable flexibility and discretion. The various measures of the money supply are now back within the Fed's own targets for monetary growth. Moreover, inflationary pressures, especially from labor costs, are low. The Labor Department's Employment Cost Index rose 6 percent over the past year, while productivity was increasing by 3 percent. Thus , the underlying inflationary pressure is now a modest 3 percent.
The short-term business outlook for the economy of the United States is quite favorable. The new standard forecast for 1983 is 31/4 percent real growth and 41 /3 percent inflation. The emerging forecast of business economists for 1984 is 5 and 5 - 5 percent real growth and 5 percent inflation. That is a good statistical definition of a healthy recovery.
The durability of the expansion in the economy will depend in large measure on the timing and strength of what is normally the second stage of the recovery. As business firms approach the limits of their capacity, they start new capital projects. These investments in the future are likely to increase in 1984. With low labor costs and rising productivity, corporate profits will be rising sharply this year and next. In fact, business profits are rising much faster than business-investment requirements. That is improving business liquidity and reducing the pressure on interest rates. The business climate clearly is turning quite positive for the coming year - but tune in frequently for the inevitable surprises!