The Pause That Refreshes?

By Charles P. Alexander

Growth is slowing, but falling interest rates encourage Wall Street

As the presidential election campaign enters its final lap, the economy is waving green and yellow flags, giving the White House cause for both concern and cheer. Government statistics released last week showed that growth is faltering and raised the specter that the U.S. might be headed for a new recession. But at the same time, interest rates dipped, lifting hopes that the recovery will gain new pep. On top of that, Britain cut the price of its North Sea oil by $1.35 per bbl. to $28.65, and Nigeria followed with a $2 reduction to $28. The breaks in oil prices and interest rates sparked an explosive rally on Wall Street.

Last week's action started when Bankers Trust in New York City cut the prime rate that it charges for business loans from 12.75% to 12.25%. That sent the Dow Jones industrial average up twelve points for the day. On Tuesday most major banks dropped their prime, but only to 12.50%. Wall Street seemed disappointed that no other banks matched Bankers Trust's half-point reduction, and the Dow slipped seven points in two days.

The bulls, it turned out, were only taking a breather. On Thursday the interest rate on federal funds, which are reserves that banks lend to one another overnight, fell as low as 9.5% from an average of 10.27% the day before. The financial markets took this drop as a sign that the Federal Reserve Board, which influences the funds rate through the amount of money it supplies the banking system, was easing monetary policy and would allow the cost of credit to fall. That plus the good news about oil caused bond prices to surge and the stock market to stampede. The Dow jumped nearly 20 points in half an hour, and its gain of 29.49 for the day was the biggest since a rise of 36 on Aug. 3. On Friday trading was again heavy, and the Dow gained a half-point to finish at 1225.93, up 35 for the week.

Wall Street's exuberance was ironic in light of other economic news. The Commerce Department announced that the gross national product, after adjustment for inflation, grew at an annual rate of 2.7% in the July-September period, down from the 7.1% pace of the year's second quarter. The drop was slightly larger than expected, but many economists welcomed it in the belief that slower growth will keep inflation from speeding up.

A separate report from the Federal Reserve Board seemed to lend support for Walter Mondale's contention that the U.S might be moving into a recession. It showed that industrial production declined .6% in September, falling for the first time since the last recession ended in November 1982. Economist James Tobin of Yale University warned that the Federal Reserve should be concerned about a new downturn. Levy Economic Forecasts of Chappaqua, N.Y., proclaimed that the recession was already here.

Government officials dismissed that gloomy talk. Said Federal Reserve Board Governor Henry Wallich: "I wouldn't take a month or two as an indication of where we're going." Assistant Treasury Secretary Manuel Johnson pointed out that corporate profits are robust, personal income is rising and inflation is moderate. Said he: "I expect the drop in production to be a temporary phenomenon."

Over the past century, expansions have lasted four years on average, and the current recovery has not yet passed its second birthday. Most private forecasters agree that a downturn is not imminent. Said Economist Barry Bosworth of Washington's Brookings Institution: "The private economy is strong enough to ensure that the U.S. will not have a recession soon." Nonetheless, a slowdown in growth is probably inevitable. Many businesses overestimated what their summer sales would be and built up excess inventories. Companies will now moderate their production to get inventories more in line with sales. Data Resources, the Lexington, Mass., consulting firm, predicts that G.N.P growth will slow to a 1% pace by the middle of 1985, but then pick up again. For all of next year, Data Resources expects growth to average 2.7%. That is lower than the 4%-to-6% range often achieved in the 1960s and '70s, but many economists think that policymakers should shoot for a slow, steady 3% pace to guard against inflationary pressures.

Perhaps a third of last month's production decline resulted from the one-week strike at General Motors. Though that dispute was settled, a walkout last week by GM's Canadian workers poses a new threat. Because vital parts of several GM cars are made in Canada, the strike could lead to a shutdown of some of the company's U.S. factories.

The health of the housing industry is particularly crucial to a continued economic expansion. Like the prime rate on business loans, the cost of mortgages is starting to ease a bit. The average interest charge on fixed-rated mortgages has fallen to 14.16%, down from a July peak of 14.67%. That decline has encouraged homebuilders to put more hammers and saws to work. Housing starts in September were up 8.9% from their sluggish pace of the month before.

Economists are divided over which way interest rates will go. Since the Reagan Administration came to office, the prime rate has gone from a high of 20% to a low of 10.5%, while mortgage rates during his term reached 18.5% and hit a bottom of 12.6%. David Levine of the Sanford C. Bernstein investment firm in New York City thinks that a slowing economy will curb credit demands. As a result, he forecasts, the prime rate could fall to 9.5% by next June. In contrast, Irwin Kellner, chief economist of New York's Manufacturers Hanover Trust, fears that rates are headed the other way. Reason: the Federal Government will be borrowing heavily to cover its budget deficit, which will be at least $165 billion in the fiscal year that began this month. The prime rate may edge slightly lower, Kellner said, but will rebound to 14% by next spring.

The direction of interest rates will depend in large part on the monetary policies pursued by Chairman Paul Volcker and his six colleagues on the Federal Reserve Board. As always, they will try to strike a balance between promoting growth and keeping inflation from accelerating. Many economists are confident that Volcker will let interest rates continue to fall if the economy shows further signs of slipping into a downturn.

Volcker will have the leeway to drop rates if inflation stays moderate, which seems likely. In addition to falling oil prices, another encouraging sign is the restraint shown this year by labor unions. The United Mine Workers agreed to a 12% wage and benefit increase over 40 months, far less than the 37.5% hike they reaped from their previous contract. Bernstein's Levine predicts that the consumer price index will climb only 3.2% in 1985, after a 3.9% increase this year.

The main danger on the inflation front is that the decline in interest rates could make U.S. investments less attractive to foreigners and send the lofty dollar into a sharp dive. A cheaper currency would make imports more expensive and thus fuel inflation. That in turn would make it more difficult for the Federal Reserve to keep lowering interest rates.

The dollar gyrated last week in jittery foreign exchange markets. At first it hit new peaks against the West German mark, Japanese yen and French franc, but as U.S. interest rates fell, the dollar began to drop. On Thursday and Friday it declined 2% against the mark and franc and 1% against the yen.

Wall Street seems convinced, for the moment at least, that the economy is headed for a period of slow, steady growth with low Inflation and declining interest rates. Some economists are not so sure. It may not be clear until 1985 whether the slowdown is the pause that refreshes or the beginning of a new bout of economic sluggishness. --By Charles P. Alexander.

Reported by Thomas McCarroll/New York and Christopher Redman/Washington

With reporting by THOMAS McCARROLL, Christopher Redman