Recovery Forecast: Not Yet

By Christopher Byron

So says the Fed chief, as money costs climb and another slump looms

Most regrettably, the year is winding up as it began: interest rates are rising, the pace of price increases is accelerating, and a growing chorus of experts and officials is warning of a downturn dead ahead. The grim prospect is of an inflation-weakened economy struggling to recover from recession, only to be knocked flat all over again by tight money and high interest--a possibility that would make 1981 as big a policymaking headache for Ronald Reagan as 1980 has been for Jimmy Carter.

Once again, moreover, the man on the spot is Federal Reserve Chairman Paul Volcker, whose 13-month-old effort to wrestle down inflation by gaining firm control of the money supply has helped roil up interest rates and keep the economy off balance. In recent months, Volcker has come under attack from the left and the right. While liberals accuse him of being too zealous in his struggle to hold the growth of money to below 6 1/2% during 1980, conservatives have rapped Volcker for consistently failing to hit his target.

Testifying on Capitol Hill last week, Volcker said he wishes that the Federal Reserve had done better at anticipating the latest money supply surge, which was fueled by the Government's need to finance the large budget deficit and by a burst of business and consumer borrowing that began at about midsummer. But in both his congressional testimony and statements to reporters, Volcker left no doubt that the Fed intends to continue "consistently and unambiguously" to restrain money and credit. Not only did he strongly deny reports that he was planning to resign before his term expires in 1983, but he pointedly punctured hopes for a brightening economic outlook ahead. Said he: "We'll have a sustained recovery only when we have the inflation rate coming down."

Upward pressure on prices remains powerful. Food costs are projected to leap by at least 12% in the year ahead, with rises of up to 18% in meat and poultry, and energy costs are about to start spurting upward again too. Though oil consumption in the industrial world is down 8% from last year's levels, and inventories are full, the ten-week-old Iran-Iraq war has cut out 9% of the non-Communist world's crude production, resulting in a tightening market that is rapidly forcing up prices. Quotes for the small amounts of crude that are regularly traded on the spot oil market have climbed as much as 30% since the outbreak of hostilities, to $39 and even $41 per bbl. Administration officials now fear this will spur militant members of OPEC to boost their own long-term prices correspondingly when representatives of the 13-nation cartel gather in Indonesia next month.

With inflation hovering at 18% in January, February and March, as measured by the Consumer Price Index, the Federal Reserve began pressing down hard on the money supply, interest rates rose and business activity plunged. In April the dimensions of the slump, which wound up cutting overall economic output by 9.6% at an annual rate in the second quarter, alarmed even the Federal Reserve, which reversed itself and began feeding money and credit back into the economy. In the process, the cost of loan money dropped, the slide into recession halted, and by late summer business was showing tentative signs of recovery.

With economic activity and inflation now picking up, the Fed has clamped down on the money supply again, and interest rates have leaped back nearly to their previous peaks, which in April reached 20% for the prime lending rate that banks charge their most credit-worthy corporate customers. That rate has once again bounded up and last week stood at 17% for such large financial center lenders as New York City's Chase Manhattan and Morgan Guaranty Trust Co. and Chicago's Continental Illinois. Bills, bonds and notes issued by the Treasury and various other federal financing agencies ranged as high as 14% in many cases, while top-rated corporate bonds yielded as much as 13.5%.

As the cost of credit has soared, businesses and individuals alike have begun to suffer. After a strong takeoff in new-car sales that buoyed U.S. automakers, business for the industry's 1981 model line has sagged to an annual sales rate of 6.6 million units, which itself would be 900,000 short of Detroit's 1981 target.

The housing industry is also being hit. With mortgage rates once again approaching 15% in many areas, buyers are simply being driven from the market. Though new construction rose slightly during October, to an annual rate of about 1.6 million housing units, most of the increase was accounted for by multifamily projects.

Starts of single-family homes were down 4.4% from September's levels, and the issuance of new permits for future construction plunged a dramatic 14.8%.

Though borrowing by corporations has helped stimulate demand for money until now, bankers, businessmen and economists expect the looming business slowdown to allow rates to fall back slight ly. Says Milton Hudson, a senior vice president for Morgan Guaranty Trust Co.: "These current rates are going to hurt economic activity as well as pinch the demand for credit. We are expecting no real growth at all during the first quarter of 1981, and it will be a close call as to whether or not the economy will actually decline."

One reason the economy is unlikely to fall by all that much in the months ahead is the prospect of a $30 billion income tax cut pledged by the new Administration. Indeed, with steadily rising Social Security taxes cutting more deeply into family paychecks, even as inflation keeps forcing taxpayers into higher income tax brackets, Reagan's cuts are intended not so much to ease the federal tax burden on the public as to raise productivity and savings by preventing increased taxes.

Yet the strategy also runs the risk of making inflation worse. Though -Reagan and his advisers insist that the tax cuts will be offset by spending reductions, the President-elect has been equally emphatic on the need to boost defense outlays at the same time. In the process, the deficit for the 1981 fiscal year that began in October could all too easily wind up swelling to $55 billion or even $60 billion instead of the $50 billion that is now projected, or the $27 billion that Rea gan is shooting for. Says Fiscal Expert Joseph Pechman of the liberal Brookings Institution in Washington: "The Reagan people are not in power yet, but they should understand that the budget has real effects on the economy."

Volcker says he can live with tax reductions, if coupled with spending cuts, but he also emphasizes that the Federal Reserve could not be counted on to pump money and credit into the economy to finance a widening federal deficit should recovery spur renewed inflationary momentum in the meantime. Said he during his congressional testimony: "I have spoken before about the potential for collision and conflict between restrained monetary growth and the financial needs of an expanding and inflating economy. Recent developments provide a taste of the potential problem." In short, unless Government under a Republican Administration proves better able to live within its means than has been the case with the Democrats, high interest and slow growth are likely to become permanent features of the American economy for years to come. By Christopher Byron

Reported by Gisela Bolte/Washington and Frederick Ungeheuer/New York

With reporting by Gisela Bolte/Washington, Frederick Ungeheuer/New York

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