Showing Some Real Muscle

By Charles P. Alexander

The recovery is proving to be powerful, but it could set off more inflation

Walter Heller, who served as chairman of President Kennedy's Council of Economic Advisers, likes to keep track of the words that his fellow economists and the press use to describe the business outlook. At last count, he had compiled a list of 60 adjectives applied to the emerging recovery. The tone of the list has been changing dramatically. Only six months ago, Heller says, economists were calling the recovery "weak, wobbly, puny, pokey, measly, muted and miserable." Now, however, the rebound has suddenly become "rapid, robust, snappy, surging, brisk, bullish and a barn burner."

Economists have good reason to rearrange their vocabulary. Upbeat statistics, from strong department-store and auto sales to improved housing starts, suggest that consumers are regaining their confidence faster than expected, and surprised forecasters are rushing back to their computers to come up with rosier predictions. Last week the Commerce Department released a preliminary "flash" estimate that the U.S. gross national product was growing at a 6.6% annual rate, after adjustment for inflation, during the April-June quarter, up from 2.6% in the year's first three months. Many economists believe that second quarter G.N.P. growth may actually hit a sizzling 8% annual rate because they think that once the final figures are in, June will prove to have been an exceptionally strong month.

The auto industry is one of the biggest gainers. Sales of American-made cars in the second ten days of June were up 73% over the same period a year ago. But the automakers also got some potentially bad news last week. The Supreme Court ordered the National Highway Traffic Safety Administration to reconsider its decision to free automakers from a requirement that they equip future cars with automatic seat belts or airbags. The safety devices could cost the automakers up to $1,100 per car, which would be added to the sticker price.

The Administration last week was basking in the sunny economic figures. President Reagan told a group of congressional leaders that "our economic game plan is working" and will lead to a "strong recovery." Martin Feldstein, chairman of the Council of Economic Advisers, said that G.N.P. growth for the entire year could reach 5.5%, nearly double the 3.1% that the White House forecast in January. "The odds are," said Feldstein, "that [the recovery] is going to continue into next year and beyond." The business community was equally elated. Said Jack Albertine, president of the American Business Conference, an organization of medium-size companies: "This is the most robust recovery this economy has seen since the early 1960s."

But to many economists, the speed of the rebound is unsettling. They point to an alarming bulge in M1, the basic money supply, which consists chiefly of currency and bank checking accounts. In the past six months, M1 has been growing at a 13.5% annual rate, despite a $3.2 billion drop reported last week. That pace could eventually overheat the economy and spark a new run-up in prices. The Fed's announced target range for M1 growth for the year is 4% to 8%. Says Rudolph Penner, an economist at the American Enterprise Institute: "If there's no clampdown on the money supply very soon, inflation will be back next year with a vengeance." Already, there are signs that inflation may be starting to creep back up. The Government announced last week that consumer prices, led by higher energy costs, rose at a 6.7% annual rate in May. For the past two months, prices have gone up at a 7% yearly clip, compared with a 3.9% rate in 1982.

The job of keeping inflation in check will rest, as it has for the past four years, largely on the shoulders of Federal Reserve Chairman Paul Volcker. Business and financial leaders cheered Reagan's reappointment of Volcker two weekends ago as a sign that the Administration is determined to hold the line on prices. The financial markets had scored big gains in anticipation of the reappointment, but after it became official, the rally cooled off. The Dow Jones industrial average declined one point last week, to close at 1241.69. Investors are cautious because they recognize what a tough assignment is facing Volcker. Says Norman Robertson, chief economist of Pittsburgh's Mellon Bank: "We have not yet solved the problem of how to sustain a recovery without reigniting the fires of inflation. This will be Volcker's task, and no one has ever pulled it off before."

Volcker is aware of the dangers. In response to a brief but very strong recession in the spring of 1980, the Federal Reserve panicked and expanded the money supply far too fast. G.N.P. growth surged to a 7.9% rate in the first quarter of 1981, but inflation roared above 10%, and Volcker was forced to slow money growth, boost interest rates and send the economy back into recession. Now that the money supply is rising rapidly again, some economists fear the Federal Reserve is making the same mistake it did in 1980. Says Lacy Hunt, chief economist with the Carroll McEntee & McGinley investment firm in New York City: "What everyone wanted was a nice, controlled, slow recovery. What we're getting is a fast, potentially disorderly recovery." Stanford Economist Michael Boskin is concerned that if excessive money growth continues too long, Volcker will have to tighten abruptly next year and risk aborting the recovery.

Administration officials last week were publicly and pointedly urging Volcker to rein in the money supply, even if that causes a modest uptick in interest rates. Treasury Secretary Donald Regan, who had reservations about Volcker's reappointment, called for "slow--repeat slow--and steady" money growth.

Though the Federal Reserve's decision making is shrouded in secrecy, some of Volcker's colleagues on the seven-member Board of Governors have privately admitted that monetary policy must be tightened a bit. One member told TIME: "There are unmistakable signs of overheating now. The animal spirits are starting to rise. If something isn't done soon, all our progress of the last three years would be at risk." The Fed governor said the Reserve Board might gently nudge up short-term interest rates, now at about 9%, to the 10% range. Many private experts, including Alan Greenspan, who was chief economic adviser to President Ford, agree that the economy can withstand a small hike in interest rates. The recovery could be cooled, Greenspan believes, without being crushed.

Volcker must be careful, though, because his actions will ripple through the world economy. Developing countries such as Mexico and Brazil are still staggering under their enormous foreign debt load. If U.S. interest rates rise enough to stall global economic growth, debtor nations could conceivably go into default and trigger a banking crisis. Says William Mason, who heads an investment advisory service in Los Angeles: "An aborted recovery would be not only a national disaster, but an international disaster as well. Volcker understands that."

Liberal economists argue that fears of a too rapid recovery are overblown. Says Heller: "We have lots of headroom for expansion and no prospect of revived inflation for quite a long stretch ahead." Heller points out that wage costs, a central element of inflation, are still declining. Harvard Economist Otto Eckstein challenges the common assumption that the money supply is expanding too fast. He notes that M2 and M3, two broader measures of money that include various types of savings accounts, are growing within their target ranges. The narrower M1 figures, he adds, may have been distorted by the swift flow of money into new kinds of interest-bearing checking deposits like the so-called Super-NOW accounts. "I believe," says Eckstein, "that M1 at the moment means nothing. It would be a great mistake to raise interest rates now."

Most economists agree that Volcker will be unable to keep inflation and interest rates down unless the Government curbs its deficits, which Budget Director David Stockman has warned may top $200 billion annually "as far as the eye can see." Figures released last week showed that in May the Government spent $29.3 billion more than it took in, the biggest one-month deficit in U.S. history. As the economy expands in 1984 and 1985, the Goverment's borrowing needs could clash with loan demands by private businesses. Such a conflict would give Volcker only two choices, both unpalatable. He could either boost the money supply enough to accommodate the deficits and thus rekindle inflation, or he could keep money tight and risk sending interest rates back to devastating levels.

Congress and the White House are still embroiled in their long-running budget brawl. The House and Senate approved a budget plan last week aimed at holding the 1984 deficit to no more than $179 billion, but the President opposes the agreement because it calls for more social spending and less for defense than he wants.

If the President and Congress cannot compromise on a budget-cutting strategy, the fight against inflation will rest squarely on Paul Volcker. With his new mandate, he seems as determined as ever to continue the struggle. "We must recognize that we are still far short of price stability," says the chairman. "In fact, inflation is only back to the pace of 1971, which was judged so intolerable at the time that wage and price controls were imposed."

No controls are in prospect, but the length and strength of the current expansion will depend upon how well the White House, Congress and the Federal Reserve Board contain prices. If they succeed, the recovery could be a long waltz instead of a brief flashdance.

--By Charles P. Alexander.

Reported by David Beckwith/Washington and Mary Ann French/New York

With reporting by David Beckwith, Mary Ann French This file is automatically generated by a robot program, so viewer discretion is required.