The American economy continues to perk along, growing in a more balanced fashion than it has for several years with few signs of accelerating inflation.
Nevertheless, problems are emerging in financial markets with renewed pressure on the value of the U.S. dollar contributing to the runup in both short- and long-term interest rates. A number of analysts believe the Federal Reserve, which raised its discount rate this month from 5.5 percent to 6 percent, will be forced to boost rates again to defend the dollar.
While the economy probably is expanding somewhat faster this quarter than it did in the second quarter, when it grew at a 2.3 percent annual rate after adjustment for inflation, it does not have up enough head of steam to withstand a major rise in interest rates.
"Much recent evidence would support the notion that the economy is running too fast," said economist Roger E. Brinner of Data Resources Inc., an economic consulting and forecasting firm. "The stock market, consumer spending, trade deficit and unemployment data all point to growth that is unsustainable without creating problems. It would therefore be appropriate to restrain credit expansion.
"It would be inappropriate, however, to slam on the brakes," Brinner told his clients. "The rise in mortgage and corporate bond rates, which began in April and was recently reinforced, is already sufficient to pull construction borrowing down sharply. Other negative factors that should be sufficient to prevent serious overheating are slower growth in federal and state-local purchases and a small increase in the consumer saving rate next year."
Certainly the Federal Reserve avoided slamming on the brakes with its half-point increase in the discount rate, the rate its charges on loans to financial institutions. Other key short-term rates rose by less than that.
On the other hand, many financial market participants felt the Fed did not go far enough. Long-term interest rates, which the central bank had hoped would come down as they did under similar circumstances in the spring with a show of anti-inflationary muscle, continued to rise. They were pushed up again at week's end when the Census Bureau reported that the merchandise trade deficit for July hit a record $16.5 billion.
Traders are concerned that the apparent failure to make progress on the trade deficit will mean further weakness in the dollar, which in turn will make foreign investors less willing to put money in the United States. That would boost interest rates and, in anticipation, the market went ahead and bid them up last week.
However, the news on trade has not been all bad. Adjusted for inflation, the deficit in trade in both goods and services, as opposed to just goods, was down in the second quarter for the third three-month period in a row. The volume of exports grew faster in each of those quarters than did the volume of imports.
The rise in exports has been a significant factor in improving the balance among different sectors of the economy this year. New orders for goods produced in American factories have been going up, partly as a result of rising export demand, and production and employment has followed. The manufacturing sector is generally healthier than it has been for some time.
Meanwhile, one deeply depressed area, agriculture, has at least hit bottom, while two others, mining and oil and gas exploration and production, have begun to improve. Increases in industrial demand have boosted metals prices. And the rebound in oil prices has put more drill rigs to work in various parts of the nation. U.S. oil production has gone down by about 800,000 barrels a day and is likely to stay down, but prices are high enough to encourage more people to take up the search for oil and gas again.
As expected, consumer spending has not grown as rapidly this year as it did from 1983 through 1986, when it rose in real terms by 4.2 percent to 4.8 percent a year. Some forecasters, such as Donald H. Straszheim, chief economist of Merrill Lynch Economics, expect a gain in that range this quarter but with much smaller increases later. Personal consumption expenditures fell in the first quarter of this year before rising at a 2.1 percent rate in the second.
"The auto industry has fallen into a pattern of overproduction followed by renewed sales-incentive campaigns," said Straszheim. "That behavior will affect the composition of third-quarter growth, but not its pace. Sharply higher car sales will cause consumer spending to spurt at a 4.6 percent rate. But plunging car sales will keep consumer spending unchanged in the fourth quarter. ... The strength of auto sales will not add to third-quarter GNP, since the cars are coming from dealers' lots, resulting in inventory liquidation."
Straszheim and most other forecasters expect consumer spending to continue to grow more slowly than the gross national product as an ever-larger portion of total U.S. production is devoted to exports. And with industrial production increasing more rapidly, so will business capital spending, these economists believe.
The latest quarterly survey of business investment intentions by the Commerce Department, released last week, indicated that all industries plan to increase their outlays for new plants and equipment by 1.4 percent this year after inflation is taken into account.
However, that estimate reflects more weak spending in the first half of the year than plans for the second half. Because of tax law changes, effective the first of this year, such investment rose in the fourth quarter of last year and then fell sharply in the first quarter. It rose in the second quarter but by much less than executives queried in the survey had anticipated. Some of that shortfall apparently is now expected to show up this quarter.
The Commerce survey has not yet asked about 1988 investment intentions, but a common theme running through economic forecasts is that business fixed investment will rise considerably faster than overall GNP next year. That GNP component fell on an annual basis last year and is likely to do so again this year despite gains in the second half.
Rising long-term interest rates could sap some of the strength of business investment, just as they are doing in housing.
Real investment in housing dropped at a 7.7 percent rate in the first quarter of this year and went down at a 2.2 percent rate in the second quarter. At Data Resources, Brinner expects that string of negative numbers to extend through 1988, when spending for new housing is predicted to drop 4.4 percent.
Housing starts reached 1.819 million units in 1986 and will drop to 1.652 million units this year, according to the DRI forecast. Next year they will drop again, to 1.511 million units.
The DRI housing forecast could turn out to be optimistic if long-term interest rates keep rising. Now that the bulk of funds to finance home mortgages is raised in the capital markets through issuance of mortgage-backed securities, movements in bond yields almost immediately affect mortgage rates. The recent surge in bond yields has pushed 30-year fixed-rate mortgages to about 11 percent, almost two percentage points higher than they were last spring.
To an unusual extent, the course of long-term rates lies in the hands of foreign investors. The United States continues to run a total deficit in its current foreign transactions of close to $150 billion, which must be financed by an inflow of foreign capital.
Those foreign investors are sensitive to the spread between interest rates in the United States and those in their own country, and to the value of the dollar, which affects the return on their investments here if they choose to take either their profits or their capital back home again.
Financial market analysts are not worried that foreign investors are going to pull out of the American market. For the Japanese in particular, there is no other capital market in the world large enough to absorb the funds they have available to invest. But simply becoming less willing to put as much money in this country can cause interest rates to rise.
For its part, the Federal Reserve still faces a delicate balancing act. It does not want the dollar to slip sharply, because that would send long-term interest rates soaring and could open the door to more inflation, as the prices of imported goods rose more rapidly. Yet supporting the dollar might require a further tightening of policy beyond the recent discount rate increase.
The Fed is also sensitive to the potential inflationary impact of further growth in an economy approaching what some economists regard as full employment levels. With real GNP growing at just over a 3 percent rate so far this year, the civilian unemployment rate has dropped from 6.7 percent in January and February to 6 percent in July and August.
While inflation rates have dropped back from higher levels recorded early this year -- much of the surge was due to the rebound in oil prices after last year's decline -- almost all forecasters expect wages to begin to rise faster in 1988. Consumer prices are expected to be going up at close to a 5 percent rate before the end of next year, and some economists think the inflation news could be worse than that.
How much of an increase in inflation the Fed will tolerate is not clear. But if the rate of wage change picks up, chances are more increases in interest rates will follow.