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But they're keeping an eye on labor markets, factory capacity, and growth overseas

The 1996 economy is a tough act to follow. Its mix of solid growth, low inflation, no interest-rate hikes by the Federal Reserve, and healthy corporate profits was heaven for Wall Street. Can this investors' paradise continue?

BUSINESS WEEK expects a generally investor-friendly economy in 1997. Recession is not on the radar screen, especially given strong labor markets, low interest rates, and manageable inventories. Also, the New Economy forces of competition and technology will continue to restrain inflation. We look for the economy to grow 2.6%, vs. a projected 2.8% for 1996. That's a bit higher than the 2.1% average of the 50 economists we surveyed (table), mainly reflecting our expectation of stronger growth in the first half, as consumer spending and manufacturing snap out of their autumn, 1996 sluggishness. We also expect 1997 inflation, measured by the consumer price index, to edge up to 3.5% from 3.2%, while the unemployment rate will end the year at 5.2%, close to where it was at the end of '96.

SKEWED. But there are risks, especially for prices and profits. ''Neither inflation nor the business cycle are dead,'' says Richard B. Berner at Mellon Bank Corp. in Pittsburgh. While most economists agree that the New Economy's structural changes are lifting productivity and curbing costs and prices, their concerns for '97 are the more traditional cyclical forces. Economists understand that the long-term trend of consumer inflation is overstated, and thus, the trends in economic growth and productivity are understated.

But for the coming year, forecasters have a wary eye on the short-term swing factors that always play a critical role in the outlook. In particular, with little slack left in the labor markets and in factory capacity, and with foreign growth set to pick up as U.S. growth chugs along, the economy is close to the point at which inflation usually picks up, regardless of what its true level is. ''About 2% growth is still the speed limit for this economy,'' says John Williams at Bankers Trust New York Corp.

The global cycle will be especially important. ''Some of the favorable international factors that held down prices in 1996 may not be as supportive in 1997,'' says Anthony Chan of Banc One Investment Advisors Corp. Because of the stronger dollar, import inflation fell from 5.6% in May, 1995, to -1.6% in October, 1996. Economists at DRI/McGraw-Hill estimate that without that drop, core consumer inflation, which excludes energy and food, would have risen slightly in 1996 instead of falling. Amid stronger growth abroad, the dollar is not likely to keep rising. Also, foreigners will use more of their capacity, and as U.S. exports rise, U.S. capacity use will tighten as well. ''The New Economy thesis will be tested when world growth accelerates in 1997 and 1998,'' says Ray Worsek of A.G. Edwards & Sons in St. Louis.

BOOM. That speedup means that foreign trade should be a modest plus for growth in 1997. Indeed, one big surprise in 1996 was the drag from trade, partly the result of weak foreign economies and the dollar's rise. Slower export growth in 1996 contributed to a sharp widening in the U.S. trade deficit, which robbed nearly a percentage point from U.S. growth. For 1997, though, ''the world economy will be in a synchronous sustained expansion, with business around the world good to excellent,'' says Allen Sinai of Primark Decision Economics. Canada and Mexico are picking up. Europe is set to improve moderately. Japan is struggling, but the rest of Asia is strong, as is Latin America.

In the U.S., consumers also will contribute positively. Fundamentals look strong, especially early in the year. Job growth slowed in the second half of 1996, but the pace is still fast enough to keep job markets tight and incomes rising faster than inflation. Confidence is near an expansion high, and long-term interest rates have fallen, spurring a round of mortgage refinancing and buoying homebuilding. Consumer debt burdens are rising, as they usually do as expansions age, but the levels are manageable as long as the job markets stay strong.

Most analysts believe that the economy will continue to walk the tightrope of noninflationary growth, but early 1997 will be the key. Holiday sales appear strong, inventories are lean, and factory orders and output are picking up. Stronger growth could set up another tussle between Fed hawks and doves. ''The interest-rate bears, currently licking their wounds after being outsmarted by [Federal Reserve Chairman Alan] Greenspan, could be back calling for tighter policy again,'' says Ian Shepherdson of HSBC Markets. About half of the forecasters expect no action from the Fed throughout 1997, while the rest are about equally divided between those who expect the Fed to tighten and those who look for a rate cut.

HELP WANTED. One of the economists' chief concerns for 1997 is cost pressures. As expansions wear on, productivity gains are harder to come by. That's especially true in this six-year upturn now that corporate restructuring is mostly behind us. And amid tight job markets, wage growth is picking up. ''A record percentage of our 600,000 member firms report hard-to-fill job openings,'' says William Dunkelberg of the National Federation of Independent Business. He adds that a record 15% say finding qualified labor is their company's biggest problem, while a record 29% are raising compensation.

The result: ''Cost squeeze dead ahead,'' warns Robert Brusca of Nikko Securities Co., and that could pressure margins and put earnings at risk. Past cost-cutting and better productivity gains than official numbers show will blunt some of the impact, but Mark Zandi of Regional Financial Associates Inc. believes there's no getting around it: ''Corporate profit growth will slow substantially in 1997,'' he says, the late-cycle result of faster compensation growth and weaker productivity gains.

In this business cycle, there is no question that the New Economy has slowed the development of cost squeezes, price pressures, and Fed tightening. But as Evelina Tainer of Indosuez Carr Futures says: ''These influences make it more difficult to discern changes due to cyclical forces and those due to structural forces.'' So here's BUSINESS WEEK's advice: Keep a sharp eye on both to avoid trouble in paradise in 1997.

By James C. Cooper and Kathleen Madigan in New York


TABLE: BW Economic Forecast Survey for 1997 (.pdf)


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Updated June 13, 1997 by bwwebmaster
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