Over the next 12 months, the U.S. economy is likely to grow at the slowest pace in five years. And for investors who are hoping to build on this year's gains, that's not a bad thing.
The slower growth is part of the vaunted "soft landing" the Federal Reserve was seeking when it began raising short-term interest rates early in 1994 to cool off an economy that seemed to be overheating. A combination of foresight and luck enabled the Fed to bring growth down to a sustainable pace while simultaneously avoiding both a recession and a surge of inflation.
Unemployment dropped to around 5.5 percent this year and then stopped falling as growth eased off. That's about as low as the jobless rate can go without triggering bigger wage increases and adding to inflationary pressures, economists believe. That's why analysts generally regard slower growth in 1996 as just what the doctor ordered. The alternative would be inflation.
The best evidence of the Fed's success lies not in the opinions of economists, but in the performance of the stock and bond markets during 1995. The Standard & Poor's index of 500 stocks rose by one-third while bonds recovered all the ground they lost in 1994.
"The sought-after soft landing came and the inflation picture remained sterling," said Sung Won Sohn, chief economist at Norwest Bank in Minneapolis. "The stock market set 67 new records during the year . . . Long-term interest rates dropped a full two percentage points."
"Can we repeat the spectacular performance of 1995? It will be difficult," Sohn said. "To begin with, economic growth will slow. The delayed effects of tight monetary policy over the past two years will still be felt in 1996." The Fed Loosens Up
But with inflation expected to stay the same or decline modestly, and with all threat of overheating gone, central bank policymakers have begun to undo the tightening actions of 1994 and early 1995. In July and again this month, the Fed lowered overnight rates by a quarter of a percentage point. Many analysts and investors expect additional cuts of half a point -- and possibly as much as a full percentage point -- during the coming year.
Falling rates and strong profit margins should help fuel further stock market gains despite 1996's slower economic growth, according to many analysts. With yields on long-term U.S. Treasury bonds below 6 percent last week for the first time in two years, the outlook for further gains in bond prices is more problematical.
"On balance, we still expect favorable trends in stock and bond prices," said Norwest's Sohn. "But we should expect periodic setbacks along the way -- 1996 won't be as good as 1995."
Some observers, such as Charles Lieberman, managing director at Chemical Securities in New York, argue that the economic fundamentals driving the markets are so strong that even a failure to get a budget agreement would not hit stock or bond prices particularly hard.
The most important of those fundamentals, in the eyes of many analysts, is a decline in the expected rate for future inflation, a decline largely credited to the Fed. The last time bond yields dipped below 6 percent, in September 1993, economic growth had been weak for several months and many investors expected it to stay that way.
In contrast, the two-percentage-point decline in long-term rates this year was driven by the realization that even strong economic growth and a low unemployment rate had not been enough to push up the nation's underlying inflation rate. The Fed's response to that danger -- which came well before most investors even saw a problem -- and its effectiveness apparently convinced many observers that the central bank could be counted on to keep inflation low in the future.
Inflation reduces the buying power of money tied up in long-term bonds, so investors try to defend themselves by requiring higher yields when they think inflation may go up. This year, it worked the other way around. As inflation expectations fell, so did long-term interest rates.
But for many investors, stocks are an alternative to bonds, and as bond yields declined, people shifted to equities. That was a key element behind the stock market surge this year. Stable Inflation Rate
Certainly, there is nothing in most economists' forecasts for 1996 that should disturb the optimism about future inflation. For one thing, there is broad agreement that virtually all the economic risks for the year are on the downside, particularly between now and summer.
Recent economic data have been "weak, not strong," said Donald H. Straszheim, chief economist at Merrill Lynch & Co. in New York. "Help-wanted advertising is down. Consumer confidence is down. Home sales have been weak. Christmas selling was weak."
Still, Straszheim and most other forecasters do not expect the economy to sputter into a recession. At the Fed, only Governor Lawrence Lindsey has expressed worry that 1996 will be marked by very weak growth, and he has given no indication he regards a slump as likely.
Aside from all the usual uncertainties surrounding any forecast, economists and policymakers have a unique problem at the moment. The Commerce Department was about to announce some significant revisions to the official figures for the gross domestic product (GDP) when major parts of the government were forced to shut down earlier this month for lack of appropriated money, a situation linked to the fight over balancing the budget.
The department has said the revisions, which involve changing the way current-dollar GDP is adjusted for inflation, will have the effect of lowering growth rates previously reported for the past several years. But details are lacking and forecasters are proceeding cautiously.
Using the new basis for adjusting for inflation, a number of forecasters have concluded that the economy can grow at about a 2.2 percent or possibly a 2.3 percent annual rate without pushing the unemployment rate up or down. Using the previous method for inflation adjustment, the comparable number was around 2.5 percent a year.
At Salomon Brothers Inc. in New York, chief economist John Lipsky and his colleagues predict -- using the new approach -- that real GDP will increase a little more than 2 percent over the course of 1996. That should leave the unemployment rate at about the current 5.5 percent at the end of next year.
Meanwhile, consumer price inflation, which ran at about 2.8 percent this year, should drop slightly, perhaps to 2.6 percent, according to the Salomon Brothers forecast.
Mickey Levy, chief financial economist at NationsBank Corp. in New York, has a similar prediction for growth but is even more optimistic on inflation. "We are looking for 2 percent consumer price inflation by late 1996," he said. The Pessimists
A few forecasters are concerned that growth will be so sluggish that some sort of unexpected shock to the economy could dump the nation into a recession. An even smaller group regard a slump as likely to hit before the end of 1996.
Among the latter is Elliott Platt, chief economist at Donaldson, Lufkin & Jenrette Securities Corp. in New York, who warned his firm's clients on Friday that "cumulating signs of weakening economic activity . . . warrant that investors seriously begin to position themselves for an impending recession."
Platt argued that the interest rate increases of 1994 and early 1995 are still weighing on the economy, while federal budget policy "is already restrictive and likely to turn increasingly restrictive." A fast move to lower interest rates might forestall a slump, but the Fed "is unlikely to reverse course rapidly enough to change the 1996 outlook greatly," he said. Platt's view notwithstanding, the forecasting consensus is that some of the forces holding back the economy at the moment -- such as the effort by manufacturers to get rid of unwanted inventories of unsold goods -- will wane in coming months. Meanwhile, the rate cuts expected from the Fed will gradually offset more and more of the impact of the rate increases of last year.
"The biggest risk to the economy in 1996 is that the Fed overstays its restrictive stance and generates a slump," said NationsBank's Levy.