ANN ARBOR—Riding the crest of a stellar 1997, the U.S. economy will remain relatively strong over the next two years, despite a greater potential for inflation and higher interest rates, say University of Michigan economists.

In their U.S. economic forecast for 1998-99, Prof. Saul H. Hymans and researchers Joan P. Crary and Janet C. Wolfe of the U-M Department of Economics predict that the economy will grow by 2.6 percent in 1998 and 2.1 percent in 1999, slowing from the torrid 3.7 percent growth rate of the current year.

This is expected to keep the unemployment rate under 5 percent during next year, but will allow it to edge up over 5 percent by late 1999, they add.

“Nobody can reasonably deny that when the U.S. economy grows by 3.7 percent from one year to the next, it’s growing at a rate in excess of its capacity, or potential, growth rate,” Hymans says. “It’s exceeding the macroeconomic speed limit.

“We kid ourselves if we think the so-called ‘new economy’ pervading the financial media means forget inflation, forget the economic ups and downs wrongly called business ‘cycles.’ There is more inflationary potential in the economic system now than there was a few years ago.”

While Hymans and colleagues expect inflation in consumer prices in 1998 to be little different from this year’s 2.1 percent, the rate is predicted to increase to 2.6 percent in 1999. Further, the prices of medical care, oil, and crude materials are expected to rise 2.9 percent, 2.6 percent and 6.5 percent, respectively, in calendar year 1999.

“These are hardly major supply shocks, but they help nudge the inflation rate up from exceptionally low in 1997 to just plain low in 1999,” Hymans says. “We expect to witness higher inflation despite the restrictive monetary policy?and the resulting economic slowdown?that we assume the Fed will institute early next year.”

The researchers say that the Fed will implement a series of increases in the federal funds rate beginning by spring 1998, pushing the rate up by 150 basis points and holding it at 7 percent through 1999.

In response, the conventional mortgage rate is expected to increase from a current 7.3 percent to 8.5 percent by the end of 1999; the three-month Treasury bill rate, currently at about 5.1 percent, should rise to 6.4 percent by late next year and remain there throughout 1999; and the 30-year Treasury bond rate is predicted to increase from a current 6.2 percent to 7.1 percent by mid-1999.

The U-M forecast, based on the Michigan Quarterly Econometric Model of the U.S. Economy and compiled by the U-M Research Seminar in Quantitative Economics, also predicts that:

• Real disposable income, or household purchasing power, will increase 3.3 percent in 1998 and 3 percent in 1999.

• Private housing starts will slip from 1.46 million in 1997 to 1.39 million in 1998 and to 1.35 million in 1999.

• Light vehicle sales will hold steady at 1997 levels, with 15.1 million in sales expected next year and 15 million the following year.

• Business capital spending will slow from a growth rate of 12.3 percent in 1997 to 6 percent in 1998 and to 3.2 percent in 1999.

• The federal deficit of $49 billion in 1997 will fall to $22 billion in fiscal 1998 before increasing again to $48 billion in 1999.

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