The Outlook Brightens

By John S. DeMott

TIME'S Board of Economists sees lower inflation and continued growth

There were a few refreshing signs of an economic spring last week, with even a soft summer breeze to be felt here and there. The Commerce Department revised its figure for the growth of the economy during the first quarter from a strong annual rate of 6.5% to an almost heady one of 8.4%. That was the highest level of economic expansion in more than two years. The Commerce Department also announced that housing starts for April rose 4.2% to a seasonally adjusted annual rate of 1.3 million units, vs. 1 million a year ago. Unemployment is holding steady at 7.3% of the work force, slightly below January's level. Even inflation showed signs of daydreaming: consumer prices increased at an annual rate of 4.9% in April, down from March's 7.4%.

The members of the TIME Board of Economists, which met last week in Manhattan, gave a much more upbeat view of the health of American business activity than they had presented at their last meeting in early February. Their outlook for the rest of 1981 is now generally favorable. The word recession is nowhere in their prognosis, although terms like pause and soggy remain.

But as if to show that the economy is in far from perfect health, most major banks raised the bench mark prime lending rate first from 19.5% to 20% and then to 20.5%, a mere 1% below the record set last December. The banks were reacting to ongoing U.S. Federal Reserve attempts to tighten credit and rein in the money supply, thus slowing the economy in order to restrain price increases.

Perhaps the most encouraging forecast by the board members is for a slowdown in inflation. They predict that it will end the year at around an 8.6% annual rate, vs. 13.2% for the last quarter of 1980. The small surplus in world petroleum markets is now keeping a tight grip on oil prices, and that will remove one of the key causes of recent inflation (see box). Homeownership costs, which account for about one-fourth of the consumer price index, are up from a year ago, but the increases are tapering off because sales are slow. Good crops and heavy livestock production so far this year should moderate food price increases in the months ahead. Finally, a stronger U.S. dollar will make the costs of imported goods lower and keep pressure on domestic companies to hold down their prices. Walter Heller, President Kennedy's chief economic adviser, concludes that the U.S. is "virtually guaranteed a lull in inflation for most of the year."

The board's members warned, however, that the economy's strong growth in the first quarter, which surprised almost all American economists, was due to factors that have now largely played themselves out. The supply of money in circulation expanded rapidly in the last half of 1980 as loans to consumers and businesses climbed. Interest rates, which had peaked in late December, declined in the early part of the year, and that too helped push growth.

The weather was favorable in many parts of the country this winter, and this helped spur buying from late 1980 into January and February. At the same time, businessmen sought to halt the rapid decline in inventories that occurred in the final months of 1980. The resulting increase in production, outside of autos, accounted for almost half of the first quarter surge. Concluded Charles Schultze, President Carter's chief economic adviser: "This economy is a lot more resilient in the face of higher interest rates than we ever thought."

Murray Weidenbaum, chairman of President Reagan's Council of Economic Advisers and former member of the TIME board, was a guest at last week's session. He described the first quarter as part of the "Reagan honeymoon." Acknowledging the special factors involved in the business surge, Weidenbaum said that he did not expect such vigor to last. The Reagan Administration's revised economic forecast, which will be issued in July, is likely to show an economy only slightly stronger than its February prediction. Said he: "I expect that real growth this year will be a bit higher than 1.1%, and inflation will be a bit lower than the 11.1% we predicted. I also still anticipate some rise in the unemployment rate during the course of this year."

The major factor holding back robust growth is those staggering interest rates. Board members expect the Federal Reserve to keep the cost of money high for some time to come. The board's consensus: interest rates will stay up, although they will ease a little by autumn. This will hold the economy's real growth for the current quarter to 1.1% and to less than 1% during the summer. The gain for the year as a whole is now expected to be 2.9%. In the gentlest terms, that amounts to a pause later in the year. Lester Thurow, M.I.T. professor of economics and management, calls such growth soggy.

Nevertheless, many unknowns hang over the economy. One is whether the $36 billion in spending cuts already approved in the congressional budget resolution will be translated into much reduced spending. If the cuts are not actually made in specific programs, the resulting deficit would likely cause additional inflationary pressures. When the details of what is to be cut work their way through various congressional committees, there will be delays and compromises, as politicians come face to face with the reality of doing less for the folks back home. But Joseph Pechman, director of economic studies at the Brookings Institution, believes that total cuts will still add up to as much as $30 billion. Said he: "I would certainly give the Congress an A-minus for that."

The TIME board also raised questions about the Administration's second round of budget cuts, notably those involving Social Security. No member of the TIME board contests that the Social Security system is in trouble. At current payout rates, the Social Security trust fund could run out of money by late 1982. There was sharp disagreement, though, with the Reagan Administration's remedy. One part of it calls for limiting the benefits of early retirees. Pechman expressed concern that the proposal would mean harsh treatment for such people.

The Administration is already showing signs of backing off on that proposal, which has met with sharp disapproval in the Republican-controlled Senate. Last week the Senate passed by a 96-0 vote a "sense of Congress" resolution voicing opposition to key parts of the Reagan plan. But that still leaves the question of what to do to keep the Social Security program from going bankrupt. Martin Feldstein, professor of economics at Harvard and president of the National Bureau of Economic Research, pointed out that benefits to Social Security recipients have risen by 30% since 1970, while the buying power of people still working has decreased by 10% because of inflation. Said Feldstein: "We must find ways to get the level of benefits down." Alan Greenspan, an economic adviser to both Presidents Ford and Reagan, pointed out that Social Security has become "less of an insurance program and more of a welfare program." All the Administration was trying to do, he said, was to "restore some sanity to the system."

Tax cuts are also an important part of the Reagan economic program. But no member of the board now believes that the Administration's proposal for a 10% cut in personal income taxes in each of the next three years stands much of a chance in Congress. They see the proposal as inflationary, a feeling that is strengthened by the year's strong first quarter. But the board still agreed that some tax cuts are necessary. Harvard's Feldstein pointed out that the Administration's proposed cuts would do little more than offset "bracket creep," which has pushed people into higher tax categories even though their real incomes after inflation have not risen. Feldstein predicted that there is likely to be pressure for "real tax cuts" later on, after Americans realize that they are no further ahead in buying power.

Feldstein and the other board members agreed that the tax cuts as now proposed would do little to boost savings to a level where they would provide the Administration's promised thrust toward industrial renewal. A more effective way of doing that would be to allow individuals to open tax-deductible retirement accounts whether or not they were covered by private pension plans. Another, says Feldstein, would be to Increase exclusions for dividends and interest received to $1,000 or even $2,000 from the current $200 per person, which he regards as "too trivial to be much of an incentive."

Pechman warned that the Reagan tax cut program in fiscal 1984 would take away $150 billion in revenues from the Government, leaving no room for savings incentives or such other popular proposals as elimination of the marriage penalty, lowering the top tax bracket from 70% to 50% on unearned income and raising the standard tax deduction. Pechman predicted that the bill finally emerging from Congress would be a mix of those features plus a much smaller cut in personal income tax rates.

The net effect of all the budget and tax cuts now either enacted or seen as having a chance of passage in Congress could lower the federal budget deficit to around $50 billion by the end of fiscal 1982, from the $60 billion or so projected for the current fiscal year, ending Sept. 30. But budget deficits in the past have often grown rapidly during the course of the spending year, and some Wall Street moneymen are fearful that the 1982 deficit may eventually be much larger than now predicted.

While Congress and the President duel over the size of budget cuts and tax cuts, Economist Thurow is concerned that the Administration's scheduled $181 billion annual net increase in defense spending during the next five years will cause major disruption in the economy. He argues that it will draw money away from the civilian sector, lavish most of the benefits on the prosperous Sunbelt aerospace industry and drain skilled workers from the private sector. Worse still, he believes, the defense buildup will harm U.S. competitiveness abroad, as the Japanese and West Germans, who already spend much less than the U.S. on defense, divert even more of their capacity toward producing better products for the civilian economy.

The crunch between military and private demands, predicts Thurow, could come in 1983 in the form of "direct head-to-head competition" for money, skills and resources like cement. Thurow argues that constructing MX missile sites could consume a substantial amount of U.S. cement production for the next decade. Says he: "No one has really thought about these things."

Other members of the TIME board, however, do not believe the defense build-up would cause an economic upheaval like that during the Viet Nam escalation of the mid-'60s, which set off the roaring inflation that has plagued the U.S. ever since. Schultze, who was the Federal Budget Director during the early Viet Nam period, said that the present circumstances are "quite different." The U.S. economy was then in the middle of a long and strong expansion, while now it is in a period of sluggish growth. Said Schultze: "Everything then went together to give us a big inflationary impact. I just don't think the current military buildup fits into the same situation."

Experts studying an economy look not only at obscure statistics but also at the broader direction of business. Those signals of economic momentum are now much more encouraging than only a few months ago. After years of going nowhere but up, inflation is now heading down a little. Although growth will not remain as strong as in the first quarter, it will be better this year than expected. The long, hard economic winter is not over, but the first real hints of a spring are there.

--By John S. DeMott

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