A Rough Road Ahead

By Barbara Rudolph

The U.S. economy has been rolling along for nearly five years now, encountering few obstacles along the way. Unemployment has dramatically declined to a seven-year low, and a record number of Americans are working. Corporate profits are rising, stocks have been on a historic climb, and most economists are predicting solid if unspectacular growth ahead.

But if things are so good, then why is there so much nervousness in the air? Why is the dread word recession turning up in more and more conversations? The inescapable fact is that the economy is facing dangerous potholes ahead that could badly jolt the expansion or even bring it to a jarring halt. The dollar has plunged to disturbing lows, and interest rates have recently spiked upward. Inflation may be roaring back: last week the Government reported that in April wholesale prices skyrocketed at an annual rate of 8.9%, the worst monthly performance since October 1985. For the same period, industrial production fell by .4%, the steepest drop in more than a year. The bad news dealt a sharp blow to the seemingly irrepressible stock market. The Dow Jones industrial average dropped 52.97 points on Friday, the fourth largest one-day decline in history, to close at 2272.52.

No wonder everyone from brokers on Wall Street to mortgage holders on Main Street shares an apprehension about where the economy is headed. Says Edward Yardeni, chief economist at Prudential-Bache: "The only thing we know for sure is that these are volatile times. We've never had such a wild mix of good news and bad news." Says Alan Weston, president of Los Angeles-based Weston Capital Management: "A lot of investors have become really unnerved by the climate out there."

Though they remain in the minority, a growing number of economists believe the proliferating danger signals may herald a downturn. Says Pierre Rinfret, an economic adviser to President Nixon: "Continued decline of the dollar, coupled with fears of higher interest rates and inflation, will produce a recession before the end of the year." Henry Kaufman, Salomon Brothers' chief economist, suggests that there could be a recession by the end of 1988.

By the most comprehensive measure -- the gross national product of goods and services -- the U.S. expansion is still moving forward. For the first three months of the year, GNP increased at an annual rate of 4.3%, the largest quarterly gain since 1984. While that surge partly reflected a rise in the production of unsold goods that will probably not be repeated in the second quarter, it was welcome news. The employment statistics provide further evidence of the economy's momentum. In April the jobless rate fell to 6.3% of the work force, down from 6.6% the previous month.

Moreover, most forecasters agree that the expansion still has a way to go. Says Alan Greenspan, a New York City-based economic consultant: "We are going to slug along." The consensus forecast of 51 economists and institutions surveyed in the Blue Chip Economic Indicators newsletter is that GNP will rise 2.5% this year and 3% in 1988. The Administration maintains its own optimistic forecast: 3.2% growth for this year, 3.7% for 1988.

The declining dollar, down in value by about 8% against major currencies so far this year, poses the greatest threat to such hopeful scenarios. The weakened greenback has contributed to an increase in inflation, since a falling dollar tends to drive up import prices. But most economists predict that consumer prices will rise this year by no more than 5%. Says University of Minnesota Professor Walter Heller: "I don't think the elements are there for inflation to feed on itself." Still, skittishness about inflation last week led to a dramatic spurt in the bellwether Commodity Research Bureau Index, as investors anticipated that commodity prices would continue to rise. The index, which tracks the prices of 26 raw materials, posted one of its largest one-day jumps ever, climbing nearly 3%, to 235.41. It closed the week at 235.59.

The weakened dollar has already forced up interest rates by reigniting more inflation fears. Investors are now demanding a higher return on fixed-income investments. From mid-March to the end of April, the yield on 30-year U.S. Treasury bonds jumped from 7.5% to 8.5%, a remarkably swift rise. By the end of last week, yields had surged to 8.9%, the highest level in 15 months. The Federal Reserve Board allowed rates to climb in order to prop up the dollar. Higher interest rates bolster the U.S. currency by making dollar-denominated investments more attractive to foreign investors.

Many bond investors have been taking a bath, since the price of fixed- income securities falls when interest rates rise. In April alone, bondholders lost more than $100 billion. The pain was shared by small investors who have poured money into bond mutual funds. At the end of March, those funds had assets of nearly $310 billion, up from $142 billion at the end of 1985. The mortgage market was also hard hit by the rise in interest rates. Says Lyle Gramley, chief economist of the Mortgage Bankers Association: "Some people called it orderly panic in the bond market. In the mortgage market, it was disorderly panic." In just two weeks in April the average rate on a 30- year fixed-rate mortgage rose from 9.25% to 10.25%.

Escalating interest rates could easily stall the economic expansion, and there are signs that more hikes are on the horizon. Last week several leading banks boosted their benchmark prime lending rates to corporate customers from 8% to 8.25%, the second time in two weeks that the key rate has risen. The housing industry is particularly vulnerable to high interest rates because home sales depend on available and affordable mortgages. But no sector of the economy will remain unscathed if rates keep rising.

The crucial question is whether the recent uptick in interest rates signals the start of a long-term trend. On this issue economists are divided. Goldman Sachs Economist Robert Giordano declares that the recent run-up will prove short lived. He expects rates to fall below 8% by the end of the year. Kaufman, of Salomon Brothers, is characteristically pessimistic, predicting that long-term rates will rise by nearly a percentage point, to 9.5%, by the end of the year.

While the falling dollar has had an unmistakable effect on interest rates, it has not yet had any tremendous impact on the U.S. trade deficit. Economists had expected that a weaker currency would have already greatly improved the U.S. trade picture by making exports cheaper and imports more expensive. But the gap between exports and imports persists, partly because Japanese and other foreign companies have sacrificed profits in order to keep their U.S. prices from rising too swiftly. Last week the Government reported that the deficit narrowed to $13.6 billion for March, down $1.5 billion from the previous month, as a result of a surge in exports. Still, for the first quarter of the year the deficit has been running at an annual rate of $163.8 billion, down slightly from last year's record $166 billion.

The small improvement in the trade situation did nothing to bolster the value of the dollar last week, as some economists had expected it would. Nor were the latest import and export statistics encouraging enough to allay widespread fears of a worldwide trade war. Many economists and foreign officials are especially concerned that the U.S. Congress will enact protectionist legislation as a desperate measure to reduce the trade deficit. Said British Trade Minister Alan Clark, speaking at last week's meeting of the Organization for Economic Cooperation and Development: "We are experiencing the most fragile conditions in the international trading system in recent memory."

The trade balance, many economists argue, will not be restored until the U.S. manages to slash its $200 billion budget deficit, which has pumped money into the economy and raised American demand for foreign goods. Says John Paulus, chief economist at Morgan Stanley: "The budget deficit is still the main problem. If you shrink it, you shrink our need for foreign capital, as well as the trade deficit."

Since Congress is unlikely to eliminate the budget deficit anytime soon, the economic hardships posed by a huge trade deficit seem certain to persist. Treasury Secretary James Baker will probably keep pushing the U.S. trading partners, especially Japan and West Germany, to expand their economies. That would enable their consumers to buy more U.S. products. At the OECD meeting, Baker made his now familiar pitch once again. But it remains doubtful that the Treasury Secretary's exhortations will produce any dramatic results.

The Federal Reserve Board will play a crucial role in determining the fate of the dollar and the trade deficit. Until now, the Fed's governors have defended the dollar and guarded against inflation by allowing interest rates to rise. At some point, the policymakers could push rates so high that they would risk throwing the economy into a recession. To some extent, then, the Fed faces the almost impossible choice of protecting either the dollar or the economy. Warns Richard Rahn, chief economist of the U.S. Chamber of Commerce: "There's clearly a danger. The Fed has much less maneuvering room than it did a few years ago." A few years ago, of course, the economic expansion was just off to a fresh start, and the road ahead did not look nearly so treacherous as it does now.

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CREDIT: TIME Chart by Cynthia Davis

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DESCRIPTION: Three charts on moving truck: Weekly closings for Dow Jones Industrials, from January 3, 1986 to May 15, 1987; Economic growth, percent changes in real GNP at annual rates from 1986 to 1st quarter of 1987; and percent of civilian labor force unemployment for the same period. Three additional charts shown as potholes are labeled U.S. DOLLAR as indexed against ten currencies from January 1986 to May 1-15, 1987; INTEREST RATES, percent per year on 30-year Treasury bonds from July 1986 to May 1-15, 1987; and INFLATION, percent change in CPI at annual rates from 1986 to 1st quarter of 1987.

With reporting by Jay Branegan/Washington and Frederick Ungeheuer/New York