For all the attention the incoming Reagan administration is paying to fiscal policy -- with impending proposals for up to $40 billion worth of individual and business tax cuts as well as major cuts in the federal budget -- the principal fact of life for the economy in 1981 and beyond will be the concrete wall of monetary policy.
Last spring a harsh monetary policy sent the economy into a tailspin after fears of inflation set off a near panic in financial markets. When the recession dried up the demand for credit, interestrates plummeted, and the economy quickly gathered itself for another run. But the wall was still there.
The strength of the recovery surprised everyone, including officials at the Federal Reserve, who were confronted by a burst of growth in the money supply generated by the surge in economic activity. Slowly at first, and then with increasing rapidity, the Fed moved to clamp down on money growth to prevent an acceleration of inflation. As a result of the collision between the swiftly rising demand for credit and the tight-fisted Fed's targets, interest rates last month again reached record levels.
Now the economy once again is weakening. Housing construction is dropping, auto sales are down, and there is a wide expectation of another slump, though not nearly as severe as the drop in the second quarter of 1980. Unemployment, most forecasters say, is set to increase again, probably heading above 8 percent.
With the Federal Reserve determined to reduce growth of the money supply over an extended period of time in order to combat inflation -- and with the incoming Reagan administration urging the central bank, if anything to be even more stingy with credit --the outlook is for the economy to move repeatedly through brief cycles of growth and retrenchment.
As Federal Reserve Chairman Paul A. Volcker put it last week: "So long as inflationary forces are strong and are expected to remain strong, money and credit targets in the area in which we are operating are likely to imply strong pressures on credit markets whenever business is strongly expanding, calling into question the sustainability of the advance."
These minicycles, however, should be smaller than 1980's abrupt swings. For one thing the Federal Reserve has no intention of repeating some of the mistakes it made last year -- mistakes that amplified the swings -- as it learned to cope operationally with a new method for controlling money growth.
Volcker also noted: "The ultimate purpose of monetary restraint is, of course to squeeze out inflation rather than real growth. But monetary restraint is at best a rough-edged tool; the restraint falls on those financing inflationary excesses and potentially productive projects alike."
While none of the relationships between money and output are perfectly precise or stable, generally speaking the Fed's likely money targets for 1981 probably will allow growth in the gross national product of between 11 percent and 12 percent. However, if inflation runs at a 10 percent rate or more, as most forecasters expect, then there is only room for a 1 percent or so expansion in real output.
Meanwhile, despite the soaring federal budget deficit, fiscal policy is actually squeezing the economy, too. Inflation is constantly pushing individuals into higher tax brackets, and a Jan. 1 jump in Social Security tax rates will take about $15 billion out of workers' paychecks this year. The excise tax on crude oil enacted last year will add another $15 billion or so to the total tax bite, up sharply from lastyear.
Thus, achieving any economic growth at all in 1981 will be dependent on the sort of massive tax cut President-elect Ronald Reagan has in mind. Whatever labels it may carry in terms of generating more saving by individuals or providing investment incentives for business, its principal effect in the short run will be to stimulate consumption -- just like all its Keynesian-inspired predecessors.
To the extent Reagan succeeds in actually cutting federal spending, he will reduce the short-run stimulative impact of the tax cuts.Chances are, the spending cuts will be smaller and come later than the tax cuts, so that overall fiscal policy will give the economy some boost in the second half of the year.
The outlook shapes up this way:
Real output -- flat at best in the first half of the year, probably with a decline at a 2-to-3 percent annual rate in the first quarter. Growth should resume in the second half at a 3-to-4 percent annual rate after the tax cuts. Output fell about 0.5 percent in 1980, and should show little change for 1981. o
Inflation -- continuing in the double-digit range but less than the 12.6 percent rate during last year as measured by the consumer price index. Energy prices will jump between 15-to-20 percent and food prices by about 12 percent. Wages and fringe benefits will go up between 10 percent and 11 percent and the employer's share of higher Social Security taxes will add another three-fourths of a percentage point to labor costs. With only a small offsetting increase in productivity expected, these cost pressures bar more than a small dip in inflation, but unless there are new shocks, such as a drought next summer or another oil-supply interuption, a percentage point or so should be clipped off the rate by year's end.
Unemployment -- increasing from December's 7.5 percent level to at least 8 percent by spring and probably staying there perhaps through most of 1981 and possibly into 1982.
Consumer spending -- falling during the first part of the year, then rising as the tax cuts and large mid-year Social Security benefit increases get spent. Auto sales, a big swing item, last month were at their lowest level for a December in six years. Social Security and other tax increases will hold down gains in take-home pay, keeping any rise in consumer spending to a very modest one percent or so for the year after adjustment for inflation. With the personal-savings rate already well below 5 percent, there is little prospect consumers would draw it down further to spend more. Similarly, with high intrest rates, it will be hard for them to get cash by selling or refinancing their homes as they did so extensively in 1978 and 1979.
Residential investment -- dropping like a stone for several months, with new housing starts reaching a 1.2 million annual rate in the first and second quarters, down from an estimated 1.5 million rate last quarter. A major casualty of anti-inflation policies, housing construction is hard hit by high mortgage-interest rates -- rates that will come down far more slowly this year than last. Investment in housing in 1981 will be slightly lower than in 1980, which was down more than 20 percent from 1979.
Business fixed investment -- declining modestly for the second year in a row. Overall, the drop would be much greater except for the feverish pace of investment in energy production. The increase in depreciation allowances that Reagan will propose will help spur new investment in plants equipment but only marginally. Interestingly, recent sharp upward revisions of figures for investment over the last decade cast considerable doubt that an inadequate rate of capital spending is a major cause of present U.S. economic difficulties.
Net exports -- changing little over the course of the year. But that relative to imports has been an important source of additional demand during the last two years.
Government expenditures -- increasing early in the year at the federal level in real terms but rising little after that, or perhaps falling, as at least some of Reagan's cuts begin to be effective.State and local outlays fell last year and will do so again this year in real terms.
The picture, then, is one of an economy at best going sideways, but more likely declining.Treasury Secretary-designate Donald T. Regan last week told a congressional committee he expects real GNP to drop in 1981 as it did in 1980.
Regan promised that President-elect Reagan shortly after he takes office will propose "a single integrated long-term plan" that will "stimulate savings, investment, growth and confidence." Reagan and others on the Reagan team are counting on convincing the public that their combination of tax and spending cuts, plus a tight monetary policy, will lower inflation. Once people are convinced, they believe, there will be in fact a quick drop in inflation as expectations change. Should that happen, those restrictive Federal Reserve monetary targets would be adequate to support more real growth because there would be less inflation.
Fed Chairman Volcker would like nothing better than to see that happen. As he said last week: "Given enough time sluggish business performance should itself tend to restrain inflation. But our objective as a nation must be to speed the disinflationary process. That will be a legitimate expectation only if we can succeed in changing attitudes and policies across a broad range of public and private behavior. Only then can we confidently anticipate that a relaxation of pressures on financial markets could be sustained, and that the stage will be set for full recovery and expansion."
But is such a change in attitudes likely? And if it occurred, how quickly would it in fact lead to lower inflation?
There are no certain answers to those questions, of course. The Reagan group says attitudes can be changed and that such a change will very quickly actually lower the inflation rate. Other economists are not so sure. One skeptic is Lawrence Chimerine, chief economist of Chase Econometrics.
"While the current inflationary cycle may have been caused initially by excess demand during the Vietnam period," Chimerine says, "it has now become primarily a cost-related inflation. Furthermore, most of the wage and price increases currently being experienced are not being made in anticipation of future inflation, but are attempts to recoup purchasing power or profits that have already been lost."
Chimerine and many other economists -- including some of those in the Carter administration who have been working toward the same ends -- applaud the Reagan goals of slowing the growth of federal spending and making federal regulation of business more efficient and less costly, other key parts of the coming Reagan plan. But they all doubt there will be anything like a quick payoff.