As usual, the economy has confounded most of the experts this year. The recovery so far is much stronger and more vigorous than most economists predicted, just as the recession that preceded it was both deeper and longer than expected.
A surge in Gross National Product in the second quarter of this year was the major blow to the forecasts of a weaker than average recovery. Much of the early evidence points to a very strong third quarter as well, although yesterday's disappointing report for July retail sales suggests that consumers may have taken a breather after their spring buying spree.
But while most forecasters have joined those in the White House and revised upwards their predictions for economic growth this year, many still worry about the prospects for recovery thereafter.
Their concern is focused on the high and rising level of interest rates. In the past few months rates have risen by close to 2 percentage points. They were already unusually high in relation to inflation, and this week's decision by banks across the country to raise the prime lending rate sent tremors through the stock market. Financiers clearly worry that the recovery may peter out.
Today's nervous market contrasts strikingly with the stocks boom of a year ago. That was fueled by expectations of lower interest rates and, as it turned out, the stock market anticipated the economic recovery. As presidential economist Martin S. Feldstein noted earlier this week, the recent interest rate increases could harm that recovery in coming months.
But whereas many economists are concerned that the high cost of money could choke off recovery, there are also those who attribute at least part of the recent rise in rates to the strength that is already in the economy. Federal Reserve Board Chairman Paul A. Volcker has said that the momentum behind the recovery is strong enough to withstand a small uptick in rates. He has also listed rapidly rising private credit demands as one factor pushing rates up, and strong federal credit demands as another.
There is in fact a two-fold explanation of high interest rates. First, the demand for money has risen strongly in recent months because of the unexpectedly rapid GNP growth together with large Treasury borrowings. But second, the Federal Reserve has tightened the supply of credit.
Although rising interest rates can be a signal of strength in the economy--when they are caused by rising credit demands--they can also be a reflection of a tighter monetary policy that will lead in turn to slower growth.
"I would guess that it's a bit of both," said Charles Schultze, chairman of the Council of Economic Advisers under President Carter.
In either case--whether the rise came primarily because of increased demand, or primarily because of a tightening on the supply side--its effect will be the same: to slow down the recovery in housing and other interest-sensitive sectors.
Volcker himself has told Congress that the Fed has tightened credit conditions mildly since May.
"If you see interest rates shooting up" at such an early stage in recovery as this, it is safe to conclude that the Fed is tightening, one economist remarked.
Some monetarists say that rapid growth in the money supply this year--in particular in the narrow M1 measure which includes cash and checking accounts--indicates that the Fed has been too loose, rather than too tight.
Feldstein said that if the money numbers later this year do not slow down in response to the Fed's actions, then the central bank should tighten credit policy another notch by restricting its supply of reserves to the banking system.
But most economists are struck by how swiftly the monetary policy makers have responded to high money numbers and evidence of rapid recovery. In previous recoveries, the Fed has been much more willing to accommodate the increased credit demands that accompany a strengthing economy.
Its actions now are witness to its determination to avoid a revival in inflation--even if that means slowing the economy while unemployment is still high, and pushing up interest rates when the dollar is already too strong and Third World debtor nations need lower rates to ease their debt burden.
Many believe that the Fed has moved too soon. "I think I would have voted for a little more gradualism," commented David Wyss of Data Resources Inc.
At a recent conference, a number of economists urged that the recovery should be encouraged. Clearly, if there was evidence that the recovery was going continue at an 8 percent annual pace, there would be a case for tightening, Schultze said. But "at this stage, there is no evidence that the recovery is out of line," he added.
Volcker has said that the Fed wanted to act quickly and gradually, giving itself the chance to reverse the tightening later on, rather than be forced to take more drastic measures if the boom continued and inflation threatened again.
But its damping tactics, according to Harvard economist Otto Eckstein, likely mean that "the best moment [of this recovery] is behind us."