U.S. economy will remain strong

ANN ARBOR—The American economy will expand at the same rate this year as it did last year, but growth will slow in 2001 as the Federal Reserve continues to boost interest rates amid rising inflation, say University of Michigan economists.

After achieving a “macroeconomic dream” of 4 percent growth, 4 percent unemployment and 1 percent inflation in 1999, the economy will scale back growth to a more sustainable level, they say.

“When we finally hit a ‘4-4-1’ year, it really was all that it was cracked up to be—superb job opportunities spread around to more and more of the population and plenty of output at stable prices,” says Saul H. Hymans, U-M professor of economics. “But there’s a big difference between attainable and sustainable.

“To think that ‘4-4-1’ is sustainable is to bet that economy-wide productivity can improve, year after year, by at least 3 percent per year, and that’s an awfully tall order—historically unprecedented.”

In their annual forecast update of the U.S. economy, Hymans and colleagues Joan P. Crary and Janet C. Wolfe predict that economic growth will maintain its 1999 rate of 4.1 percent this year before slowing to 2.7 percent in 2001.

The U-M researchers say that the Fed will continue to raise interest rates, with the current federal funds and discount rates (interest charged by the Fed on loans to banks and which, in turn, affect consumer interest rates) up 100 and 75 basis points, respectively, since last summer.

The conventional mortgage rate is expected to increase from 7.4 percent in 1999 to 8.6 percent this year to 9.2 percent in 2001. The rate for three-month Treasury bills is forecast to rise from 4.6 percent last year to 6.1 percent in 2000 and 6.9 percent next year, while the 10-year Treasury bond rate should climb from last year’s 5.6 percent to 7.1 percent this year and 7.5 percent in 2001.

“The Federal Reserve seems, quite clearly, to have taken the position that the economy will be better off in the long term if it’s induced to live within its resource constraints in the near term,” Hymans says. “To try and make that happen, the Fed has been pushing short-term interest rates up and, in recent weeks, Fed Chairman Alan Greenspan has all but announced that further increases in interest rates are to be expected.

“We predict increases totaling another 100 basis points by this summer, after which we expect the Fed to hold steady through the national election season before resuming its tightening course with increases adding another 75 basis points to short rates in the first half of 2001.”

In addition to rising interest rates, the forecast calls for greater inflation and less growth in real disposable income over the next two years. Inflation is expected to increase from the 1999 rate of 1.1 percent to higher, but still moderate, rates of 2.3 percent in 2000 and 2.8 percent in 2001. Disposable income will rise 3.3 percent this year and 3.7 percent next year, compared with a 4 percent rate of growth in 1999.

Unemployment, the U-M economists say, should hold fairly steady throughout the forecast period, from a rate of 4.2 percent last year to 4.1 percent in 2000 and 4.4 percent next year.

Hymans and colleagues caution that a scenario of strong growth and mounting inflation, coupled with low unemployment, may cause the Fed to further tighten fiscal policy going into 2002.

“Now that tight budgeting, rapid economic growth and a booming stock market have combined to produce a pretty hefty budget surplus, the real question is how much fiscal discipline will survive in the years ahead,” Hymans says. “Our basic assumption about fiscal policy is that the federal government will devote most of the budget surplus prospectively available in the coming years to debt retirement.

“The alternative is that the fiscal authorities turn overly expansionary with substantial tax cuts and/or spending increases—and the political pressure to do so may well become increasingly difficult to resist. Should that alternative eventuate, however, the Fed is almost sure to react with even higher interest rates than we have already assumed.”

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:

—  The federal budget surplus will grow to $152 billion in fiscal 2000 and $151 billion in 2001, up from $102 billion last year.

—  Sales of light vehicles will set a new record this year at 16.9 million units, before scaling back to a still-strong 16.2 million cars and light trucks in 2001.

—  Private housing starts will drop from 1.67 million units in 1999 to 1.66 million this year and 1.55 million next year.

—  Business capital spending will increase by 8.7 percent in 2000 and 7.1 percent in 2001.

—The value of the dollar will rise by 0.8 percent this year before declining by 1.6 percent next year.

Federal ReserveeconomicsAlan GreenspanResearch Seminar in Quantitative Economics