Slower Growth Expected As Fed Tightens Its Grip

Consumer confidence is up, the jobless rate is down, factories are running near full capacity and U.S. economic output expanded by about 4 percent this year.

Is all that good news going to mean bad news in 1995 and heading into the crucial 1996 election?

Many economists believe the economy will start slowing as early as the spring, as the interest rate increases engineered by the Federal Reserve this year finally put the brakes on the economy’s expansion.

“We think the economy will slow rather abruptly,” said David Wyss, an economist with DRI/McGraw-Hill in Lexington, Mass.

Fixed-rate home mortgages could reach or surpass 10 percent, said Lyle Gramley, a former member of the Federal Reserve Board.

What Federal Reserve Board Chairman Alan Greenspan is trying to do is engineer a “soft landing,” that will slow growth enough to prevent inflation from taking off while allowing economic output to continue to increase.

Greenspan tried the same strategy in 1990, but the economy dipped into a recession. This time, Greenspan acted early - too early for some politicians and economists - and raised short-term interest rates by 2.5 percent during 1994.

Even with higher rates, the economy continued to grow. The Gross Domestic Product, the broadest measure of economic output, increased by a surprising 4 percent during the fall. The Consumer Price Index, a measure of inflation, increased 0.3 percent in November. Prices are up 2.7 percent from November 1993.

Wyss said the longer the economy continues to show strength, the higher the Fed will have to move interest rates and the more likely the economy is to dip into a recession.

“Either inflation is going to get way out of hand or the Fed is going to tighten monetary policy even further,” Gramley said.

“We can’t create another 3.5 million jobs - unemployment is way too low now,” he said. “We can’t continue to see capacity utilization (at factories) continue to grow.”

Unemployment was 5.6 percent in November, down from 7.2 percent a year earlier.

Generally, Fed watchers believe Greenspan wants the economy to grow about 2.5 percent with stable inflation.

Fed watcher David Jones of Aubrey G. Lanston & Co. in New York said he believes the Fed will raise short-term rates two more times in 1995, raising the fed funds rate to about 7 percent. The central bank raised the Fed funds rate - which banks charge each other for money - by three-quarters of a percentage point to 5 1/2 percent in November.

“I think that’s enough to get a soft landing,” he said.

John Silvia, an economist with Kemper Financial in Chicago, said he believes the Fed’s earlier interest rate hikes are circulating through many of the sectors of the economy that are closely linked to the business cycles.

He said the auto industry, which has been booming, as well as other durable goods, are near their peaks. Silvia also said business investment in inventories, new equipment and buildings will slow next year.

“1994 will be shown to be the strongest year of this recovery,” he said.

Gramley said a soft landing probably would have been more achievable if Greenspan and other economists had foreseen the strong growth in 1994.

Wyss said DRI/McGraw-Hill is forecasting that economic growth will slow to a rate of less than 2 percent by the end of 1995, and remain under 2 percent in 1996, the election year.

“I don’t think that looks good for President Clinton,” he said. “Inflation will be low, but growth will be sluggish. It will look to the voters a lot like 1992.”

Still, he said, “Slow growth is a heck of a lot better than a recession.”

Silvia said the Fed may raise interest rates even more if Congress and the Clinton administration agree to cut taxes in 1995 and 1996 but delay spending cuts until 1996 and 1997.