Waking Up From a Slump Time's Economists Foresee Stronger Growth, Thanks to The

By Charles P. Alexander

After taking a snooze during the winter, the U.S. economy now appears ready to shake off its lethargy and get moving again. That was the optimistic forecast of TIME's Board of Economists, which met last week in Washington. The members see the U.S. economy growing at a solid 3% annual rate for the rest of the year.

For the past few months, American business has been close to comatose, and fears of recession have been increasing. The Commerce Department reported last week that the gross national product, after adjustment for inflation, grew at an annual rate of only .7% during the first three months of the year. That was down sharply from the 4.3% gain in the final quarter of 1984. In addition, corporate profits are off, capital spending is sagging and unemployment is stuck at 7.3%.

But new signs that the Federal Reserve Board is easing monetary policy and letting interest rates fall have raised expectations that the economy will avoid a recession and rebound rapidly. Said Board Member Walter Heller, a University of Minnesota professor who was chairman of the Council of Economic Advisers during the Kennedy Administration: "The Fed is riding to the rescue." Agreed Alan Greenspan, who served as chief economic adviser to President Ford: "The odds definitely favor a quickening of the economy."

The Federal Reserve signaled its intention to ease credit two weeks ago when it dropped the discount rate, which is the interest it charges on loans to commercial banks and savings institutions, from 8% to 7 1/2%, the lowest level in almost seven years. That spurred most major banks to reduce the prime rate they levy on business loans from 10 1/2% to 10%. This action will help many businesses finance expansion plans and may also lead to lower interest on some consumer loans. TIME's economists forecast that the prime rate will fall at least another notch, to 9 1/2%, before leveling off. M.I.T. Professor Lester Thurow predicted that the prime rate will decline to 8% by the end of the year.

The drop in interest rates energized Wall Street for a while. On Monday, which was the first business day after the discount rate cut, the Dow Jones industrial average surged 19.54 points to finish at a record 1304.88, its first close above the 1300 barrier. The bulls tacked additional 4.82 points onto the Dow average on Tuesday, lifting it to a new peak of 1309.7. At that point the market began suffering from one of its recurrent afflictions: acrophobia. Investors started cashing in some of their profits, sending the Dow back down. The industrial average finished the week at 1301.97.

Economic growth would have been much stronger in the first quarter were it not for a torrent of imports, which added to an international trade deficit that hit a record $123 billion in 1984. Though Americans spent freely early in the year, they were favoring many foreign goods over domestic products. As a result, production in U.S. factories stagnated. The main reason for the import binge was the strength of the dollar, which until the last few months seemed to be rising inexorably. Between 1980 and last February, the value of the dollar climbed by more than 60% against an average of major currencies. That increase devastated many American manufacturers by making their exports more expensive abroad and imports cheaper in the U.S.

Since February, however, the dollar has fallen from its dizzying heights. It has dropped about 4% against the Japanese yen, 11% against the West German mark and 24% against the British pound. This trend will help American companies compete with foreign goods, and may eventually bring down the trade deficit.

Another bright sign for the economy is that consumer confidence and retail sales remain robust. Several department store chains last week reported hefty profit gains during the first three months of the year. Earnings were up 17% at Allied Stores, 18% at Dayton Hudson and 21% at Federated. Auto sales in mid-May rose 18.2% over the same period a year ago.

One of the most buoyant parts of the economy is the housing industry, which is benefiting from a decline in mortgage rates. Surveys by the Shearson Lehman Brothers investment firm show that the average interest charge on a fixed-rate mortgage for 25 years or more has dipped from 14.5% to 12.7% since August. During that time, the rate of housing starts has jumped 19% to its highest level in a year. The upswing in homebuilding will ripple through the economy, generating sales for companies that make products as diverse as lamps, linoleum and refrigerators.

The Federal Reserve Board is able to let mortgage and other interest rates decline because inflation seems dormant. The Labor Department reported that the consumer price index rose at a moderate 4.6% annual rate in April and at a 4.2% clip for the first four months of the year. Inflation has been about 4% since 1982, and TIME's economists forecast that this pace will continue through the rest of 1985.

In the past, inflation has often flared up when consumer demand outstripped the ability of American factories to produce enough goods. But that is not likely to happen again soon, Economist Heller pointed out. He noted that U.S. companies are expanding their factory capacities by 5% this year, according to a McGraw-Hill survey, and that current plants have plenty of room for new production. Said Heller: "Excess-demand inflation is not onstage or in the wings."

The economists admitted, however, that a few lurking dangers could ambush the economy. For one thing, public confidence in the financial system is fragile in the wake of the savings and loan crises in Ohio and Maryland. So far, the trouble has been limited to institutions without federal insurance, but Greenspan is concerned that the uneasiness of depositors could spread. Said he: "Although the Ohio and Maryland savings and loan situations are of negligible dimension, they are scaring everyone silly. If people ever became disaffected with the federal insurance system, you could get emotional runs on the S and Ls that would be difficult to stem."

A second peril is the possibility of a loss of faith in the U.S. economy by foreign investors. In the past three years more than $250 billion has flowed into the U.S. from abroad. That money has been a big help in financing the federal budget deficit, which will top $200 billion this year, and keeping interest rates from rising. If foreigners sharply reduced their investments, the dollar might plunge much more steeply than it already has, and interest rates would jump. While noting that some experts fear such an event, TIME's economists think that the odds are against it. Said Rimmer de Vries, a senior vice president for New York City's Morgan Guaranty Trust: "We don't expect the dollar to collapse." In fact, De Vries said that as the U.S. economy speeds up, the dollar may begin to strengthen a bit.

Charles Schultze, a senior fellow at Washington's Brookings Institution, warned that the U.S. could not rely on foreign capital indefinitely. Though he doubted that interest rates will rise anytime soon, he said that a diminished flow of money from overseas could eventually drive up the cost of borrowing. The only way to keep rates down, Schultze maintained, would be to slash the federal deficit. Said he: "If more is not done about the budget problem, we will probably see interest rates a lot higher by 1987."

The economists were optimistic that Congress and the White House are making a serious start toward resolving the budget dilemma. "I think we are getting closer and closer to a real breakthrough on bringing the deficit down," said Harvard Professor Martin Feldstein, who served for two years as President Reagan's chief economic adviser. The board was particularly encouraged by the resolution passed three weeks ago in the Republican-controlled Senate, which was designed to trim $56 billion from the 1986 budget, leaving a deficit of $171 billion. The plan would, among other things, eliminate the 1986 cost of living increase for Social Security recipients, limit the rise in military spending to the rate of inflation and phase out twelve federal programs, including Urban Development Action Grants and General Revenue Sharing for states. Heller said cuts of that magnitude could ultimately reduce the deficit to $144 billion by 1988. That would bring the budget shortfall down to 3% of GNP, compared with 5% this year. "We could be going through a watershed on the budget deficit," said Heller.

Feldstein cautioned, however, that the Senate may have a problem with the Democrat-controlled House, which last week adopted a plan that makes deep cuts in defense spending but leaves Social Security untouched. He said that the House proposal may lack credibility in the financial markets because it retains most of the federal programs that the Senate wants eliminated. But Alice Rivlin, director of economics studies at Brookings, was hopeful that a compromise between the House and Senate versions could be reached in a conference committee.

The other deficit that the U.S. urgently needs to shrink is the trade one. That will be possible, said De Vries, only if Western Europe and Japan expand their economies at a faster clip and buy more goods from the U.S. In recent years many countries, including Britain and West Germany, have pursued restrictive policies to guard against inflation. But now, TIME's economists agreed, the inflation threat has subsided enough that these nations could safely stimulate growth by passing tax cuts and other measures. In return, however, the U.S. must slice its budget deficit. That would make it possible for the Federal Reserve to let American interest rates fall still further.

Over the past two years, the U.S. led the rest of the world out of a recession. When the American economy stalled early in the year, fears began to grow around the globe. But if TIME's economists are right, the U.S. will soon become the pacesetter again.

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