And The Beat Slows Down

By GEORGE J. CHURCH

It's ba-a-a-ck! The business cycle, that economic beast from 20,000 fathoms, is poking up its head again. The rushing tides of the new economy kept it submerged for almost a decade, but they could not drown it for good. It lives! Only it now looks like a pretty tame beast. A little slower growth in U.S. production, a little more inflation before the slowdown takes effect, a bit more unemployment, eventually, maybe...that's about the worst damage that the cycle is expected to inflict. Unless...

Such was the consensus of TIME's Board of Economists, which gathered in late May in Manhattan to assess a rapidly changing business outlook. For the first time in at least two years, members concurred, not all economic systems are go. Imbalances are showing up, notably a worsening labor shortage and excessive consumer spending; signs of renewed inflation are real; stock markets have turned turbulent, to say the least. Allen Sinai, chief global economist of Primark Decision Economics, long contended that rising productivity in the new economy enables the U.S. to enjoy noninflationary increases in production much greater than once imagined. He now concedes that this picture has been temporarily pushed aside. "For the first time in over a decade," he says, "a standard business-cycle pattern is moving front and center."

Why? Most important, of course, because the Federal Reserve under Chairman Alan Greenspan has been raising interest rates for just short of a year to slow a runaway boom. Members of TIME's board differ considerably on how soon and how hard those rate hikes will bite. But all agree on two predictions: 1) there will indeed be a slowdown; 2) the chance that it will turn into a recession is, in Sinai's word, "zero." Diane Swonk, chief economist of Bank One and president of the National Association for Business Economics, declares, "I expect this expansion to last until 2004"--which is as far as she will predict.

At present there are signs a slowdown may be under way, but the economy's overall momentum is still quite powerful. Total production of goods and services rocketed ahead at an annual rate of 5.4% in the first quarter. That was below the superheated 7.3% pace in the previous three months yet still well above what the wildest optimists would consider a sustainable pace. However, Chris Varvares, president of Macroeconomic Advisers, a consulting firm with headquarters in St. Louis, Mo., expects a "fairly abrupt" slowing in the second half of the year to below 3%, which will hold gross-domestic-product growth for the year to 5%. Ed Yardeni, chief economist of Deutsche Bank, agrees, largely because he believes the skyrocketing rise of stock prices in late 1999 and early this year "most likely did contribute to boosting car sales and housing-related sales." With the NASDAQ index by late May down roughly a third from its March peak, he says, "within the next couple of months we'll find weaker car sales, weaker retail sales, weaker housing activity." Varvares expects a further slowdown to about 2 1/2% growth in 2001, though he thinks the pace will pick up again by next year's end.

Swonk looks for a more prolonged slowing. The boom has been powered lately by consumer spending, she says, and that spending is less sensitive to interest-rate boosts than it was in the past and not as sensitive to stock-market gyrations as many would suggest. She figures that real wage increases--that is, pay raises minus price boosts--will be "nipping up into the 4% range" by year-end. Her conclusion: "You never bet against U.S. consumers when they've got money in their pockets to spend, and these consumers have a lot of money to burn." Swonk expects GDP growth to slow from more than 5% in the first quarter to about 4% for the rest of 2000. She adds, though, that "the economy will slow more dramatically in 2001, but still not enough to derail the upward pressure on inflation that has taken root in labor markets."

Would the Fed then raise interest rates further still? Maybe--but just how much and how long it will continue to crack down is the biggest uncertainty in the outlook. Since June 30 of last year, the Federal Reserve system has pushed up the so-called Fed funds rate (a very short-term rate that it effectively controls) 1.75 points, to 6.5%. Yardeni thinks it will stop there, but he is a minority of one. All the other members of TIME's Board of Economists expect it to go up to 7% or 7.5% by year's end; Swonk and Varvares believe it may rise to 8% next year. And Swonk thinks even that may not be the peak. The reason: Fed Chairman Greenspan seems dead serious about reducing the annual growth rate to around 3.5% to 4% and the inflation rate to somewhere around 2%. Most members of TIME's board think the rate boosts so far are not enough to do that job.

Lawrence Kudlow, chief economist of CNBC.com is an exception. Though he expects the Fed to boost rates to 7.5%, he thinks that will be an error reflecting "buggy-whip" thinking. Even the increases so far, he believes, were unnecessary. In his view the Fed itself caused the surge in output in late 1999 and early this year by pouring money and credit into the economy to guard against any disruptions that might result from Y2K computer breakdowns. No such breakdowns occurred, of course, so the Fed is now throttling back the growth of money supply. That, says Kudlow, will be enough to slow production growth to a sustainable, noninflationary rate, which he expects to be achieved by year-end, after a brief "wiggle wobble."

Varvares voices the opposing view: the U.S. economy has been "exceeding its speed limits" for some time. Inflationary pressures were held in check because of higher labor productivity in the U.S. and by a worldwide plunge in commodity prices caused by the Asian economic collapse of 1997-98. Once that short-lived drop was over, a wage-price spiral began, caused largely by the labor shortage, which, in turn, reflects the too rapid growth rate. Sinai notes that wages rose at an annual rate of 4.8% from October 1999 through March of this year, while overall consumer prices have risen lately at a nearly 5% annual rate.

The Fed, says Varvares, fell "behind the curve" in fighting these trends. Sinai agrees and thinks Greenspan and his colleagues now have only a 30% chance of bringing about an ideal "soft landing"--a quick slowing of production growth to around 3.5% next year with an inflation rate "heading back toward 2%." Sinai sees a fifty-fifty likelihood of a "hard-soft landing," meaning growth at 2.5% for a year or so beginning in 2001.

Sinai's worst-case scenario, which he gives a 1-in-5 chance of coming true, is a "hard landing," meaning growth of 2% or less for a year or so. That would still not be a recession, defined as an actual drop in output, but it would have "recession-like characteristics," says Sinai--one of which would probably be rising unemployment, along with sagging business profits.

What could trigger such a development? One obvious risk is that the Fed could crack down too hard and too long on interest rates and money supply. Another is that a continuing slide in stock prices would deepen into a raging bear market that would depress both consumer spending and business investment. Swonk is worried that the occasional market rallies this year have been prompted by hopes the Federal Reserve will soon stop raising interest rates. She fears that if those hopes are disappointed, as she thinks they will be, stock prices could be vulnerable to a more dramatic correction next year.

Despite these worries, the board consensus is at least moderately optimistic. A soft or even hard-soft landing for the economy would not be very painful compared with bumps of the past. No one, for example, sees much of a rise in unemployment as likely. Sinai and Varvares think the momentum of the economy may push the jobless rate to 3.8% by the end of this year, even lower than the 30-year low of 3.9% reached in April. Unemployment can then be expected to increase a bit as the Fed-engineered slowdown takes hold, but no one seems to think it will go much higher than 4%, which is becoming accepted as practical full employment.

Best of all, members of TIME's board unanimously expect any slowdown to be no more than an interlude in what Kudlow calls "a long wave of technology-driven prosperity." He opines, "It's going to go on for a couple more decades." While his colleagues will not go quite that far, they agree that rising productivity will cushion the shock of slowdown and lead to greater gains when growth speeds up again. Swonk argues that "much of the productivity growth we see today results because we have figured out how to use network computers, not necessarily because of the birth of the Internet. Those gains [from optimum use of the Internet] are still ahead."

The sharpest dispute among TIME board members concerned whether there are any limits at all to long-term growth. Yardeni and Kudlow think not. Sinai, Swonk and Varvares believe there are, but add that these limits are far less restrictive than the ones previously thought to exist. Their thinking now is that the economy can hypothetically average growth of 3.5% to 4% a year, for years on end.

Not that the numbers will be the same every year, of course. Sinai believes business cycles will continue, but they will consist of fluctuations above and below these new norms, rather than the old dizzying swings between boom and bust. The new economy and the business cycle both live--only the cycle is not the beastly menace it used to be.

--With reporting by Bernard Baumohl/New York

With reporting by Bernard Baumohl/New York