Trying to Puff Up the Sails

By Charles P. Alexander

Interest rates are falling, but is the drop too late to save the recovery?

More than President Reagan or anyone else, Federal Reserve Chairman Paul Volcker caught the blame for the 1981-82 economic downturn. Now he is in danger of becoming the villain of Volcker Recession II. To prevent that unsavory sequel from materializing, the Federal Reserve Board has softened the tight-money stance it adopted earlier in the year and is letting interest rates fall. As a result, by last week a bidding contest was under way as banks rushed to drop the prime rate that they charge corporate borrowers. First New York's Citibank led a group of institutions that lowered their prime from 11.75% to 11.50%. Then another wave of banks, including Chase Manhattan and San Francisco's Bank of America, pushed the prime down to 11.25%.

But a question still haunts businesses and consumers: Has Volcker's rescue mission come too late to save the recovery? Growth in the gross national product, after adjustment for inflation, plummeted from an annual rate of 8.6% in the first half of the year to only 1.9% in the July-September quarter. And bleaker news may lie ahead. The Commerce Department announced last week that the index of leading economic indicators, a barometer of future growth, fell .7% in October. It was the index's third decline in the past five months.

Most economists believe the economy is merely coasting for a while, not collapsing. The consensus of four dozen forecasters surveyed monthly by Robert J. Eggert for his newsletter Blue Chip Economic Indicators is that G.N.P. growth will pick back up to 3.3% in 1985. A growing number of analysts, however, are more skeptical. Says Sam Nakagama, a Wall Street economic consultant: "We are already in the midst of a mini-recession, and the danger is that the economy will slide into a full-fledged recession."

Federal Reserve officials brush aside such doomsaying. Says Volcker: "The current pause in economic growth need be no more than that." Agrees Anthony Solomon, president of the New York Federal Reserve Bank: "These signs of outright weakness are likely to prove temporary."

The Federal Reserve is in a much better position to ward off a recession than it was in 1980. At that time, inflation was 12%, and Volcker had little choice but to give the economy a cold shower. This year price rises have been so modest that Treasury Secretary Donald Regan has taken to asking in the manner of Clara ("Where's the beef?") Peller, "Where's the inflation?" Since January the consumer price index has risen at an annual rate of 4.5%. Producer prices, which often foreshadow trends in consumer costs, have gone up at a mild 1.8% pace so far this year and have actually declined for the past three months. Many economists think Volcker has room to nudge interest rates down by perhaps another percentage point without rekindling inflation.

The swiftness of the economic slowdown caught the Federal Reserve by surprise. In the spring, growth was going like a greyhound, and an acceleration of inflation seemed a real possibility. As demand for loans surged, the Reserve Board let the prime rate creep up from 11% in March to 13% by the end of June. Volcker kept the prime at that lofty level all summer in hopes of easing the economy onto a slower, more sustainable growth path.

His strategy worked. In fact, it worked too well. Hefty mortgage rates hammered the housing industry, and the pace of construction faltered, hurting sales of everything from timber to toilets. Consumers turned cautious and scaled back borrowing and spending. As inventories mounted on store and factory shelves, companies curtailed production.

Tight money had an especially harmful effect on international trade. Because high interest rates have enticed foreigners to invest increasing amounts of money in the U.S., the value of the dollar has stayed at an exceptionally high level this year against most major currencies. That has made imports unusually cheap for American buyers and U.S. exports expensive overseas. An import flood has washed away thousands of American jobs and produced a U.S. trade deficit twice as high as any other shortfall on record: a projected $130 billion in 1984. Federal Reserve officials calculate that without the trade deficit G.N.P. growth might have been about 6% in the third quarter instead of 1.9%. Economist Robert Giordano of the Goldman Sachs investment firm in New York City fears that the U.S. may be "importing its way into a recession."

Critics of the Federal Reserve say that it waited too long to let interest rates fall. They point out that M1, the basic money supply that includes cash and checking accounts, showed almost no increase between June and November. Only in the week ending Nov. 19 did M1 finally start to move sharply with a $6.7 billion rise. Says New York Republican Congressman Jack Kemp: "I wish the Fed had acted earlier. We have paid a price in lost growth and lost jobs." Says Paul Craig Roberts, a professor of political economy at Georgetown University: "The Fed has dawdled when the evidence of a serious downturn in growth has been there for all to see." Others argue that because of the time it takes to gather and compile economic statistics, the Federal Reserve had no way of knowing how much damage it was doing. Says James Annable Jr., senior domestic economist for First Chicago Bank: "The Fed operates in the dark to the same degree as anyone else."

Some economists fault banks for being reluctant to drop their loan charges. The Federal Reserve began increasing the flow of money into the financial system in September, but banks were slow to pick up the cue. By mid-October the prime rate had fallen only from 13% to 12.5%. Observes Donald Maude, chief economist at Refco Partners, a Wall Street investment firm: "Banks were trying to protect profit margins." The reason: bankers wanted to build up reserves to offset expected losses on problem loans.

As the presidential election campaign entered its final weeks, the Administration became increasingly impatient with the banks and the Federal Reserve. In his weekly breakfast meetings with Volcker, Regan urged the chairman to take more aggressive action to force interest rates down. Last month Regan stepped up his campaign in public, complaining that the central bank "could be a little more accommodative" and warning Federal Reserve officials that the Administration would "have to have a few words with them."

Two weeks ago Volcker flashed the sign that the White House wanted to see. The Federal Reserve cut the discount rate, which it levies on loans made to member banks, from 9% to 8.5%. It was an unmistakable signal for banks to lower the interest rates they charge customers. Even some of Volcker's harshest critics are now optimistic, if not entirely satisfied. Says Richard Rahn, chief economist for the U.S. Chamber of Commerce: "The Fed has reacted late and it has probably not gone far enough, but I think we can avoid a recession. The economy should rebound." Administration officials share that view. Says Manuel Johnson, the Assistant Treasury Secretary for Economic Policy: "There's time to move things back on track."

That will happen only if consumers regain the urge to splurge. The latest Commerce Department figures show that retail sales slipped slightly in October. R.H. Macy, the department-store company, reported last week that its profits fell 27% in the three months ending in October, but said that sales picked up in the first days after Thanksgiving, the traditional start of the all important Christmas shopping season. Several other retail chains, including Dayton-Hudson and K mart, are also reporting brisk holiday business. Concludes Robert Ortner, chief economist of the Commerce Department: "The odds still favor a very good Christmas." He thinks the drop in interest rates will bolster consumer confidence.

Auto sales may give a spark to the economy. Much of the production slowdown in the third quarter resulted from strikes against General Motors by U.S. and Canadian workers. The walkouts and quotas limiting Japanese auto imports have intensified the current demand for cars. The automakers reported last week that sales of

U.S.-built cars were up 29% in the middle ten days of November from the same period a year ago. General Motors scored a 17% gain, Ford's sales rose nearly 50% and Chrysler's jumped 62%. The auto companies plan to lift their production by 15.5% in the first quarter of 1985, compared with the last three months of this year.

Many forecasters expect the Federal Reserve to let interest rates fall further to make absolutely sure that a recession is averted. James Smith, chief economist of Union Carbide, says that the prime rate will probably be down to 10.5% by the end of the year. That should be enough, he predicts, to spur G.N.P. growth into the 4%-to-5% range for the first half of 1985.

But if Volcker is too generous with the money and interest rates drop too far, foreigners could start shunning U.S. investments and send the dollar into a steep decline. That might cause a sudden burst of inflation by making imports more expensive. For the moment, though, the dollar seems to be holding its own. On the day Citibank led the prime-rate cuts last week, the dollar surprisingly rose against the deutsche mark and the French franc. One reason for the dollar's continued strength is that foreign central banks, especially in Western Europe, have been reducing interest rates in their countries just as the Federal Reserve has in the U.S. As a result, many overseas investors are still content to keep their money in the U.S. Says Volcker: "With the dollar so strong internationally, I believe we have more flexibility in the conduct of policy than for some time."

The most ominous threat to Volcker's strategy is the federal budget deficit, which is now expected to reach $210 billion in 1985. Even if he manages to revive the economy, Government borrowing may force interest rates up again next year and throttle growth. More and more business and financial leaders are publicly demanding that action be taken to reduce the deficit. In a speech in Washington last week, Robert Kilpatrick, chairman of the Cigna financial services company, summed up the rising concern. Said he: "We must solve this critical problem today or we face a much deeper problem tomorrow."

Unless President Reagan and Congress settle their differences and attack the deficit, the odds for recession or swift inflation, or a combination of both, will rise. The burden of avoiding those dangers--fairly or not--will rest squarely on the shoulders of Paul Volcker. If he fails, he may be the scapegoat once again for the political stalemate between the White House and Congress.

--By Charles P. Alexander.

Reported by Christopher Redman/Washington and Frederick Ungeheuer/New York

With reporting by Christopher Redman, Frederick Ungeheuer