View PDF

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.


y B | i

UNIVERSITY ° y \ { i n n c s o t c i

D E PA R T M E NT OF E C O N O M I C S • M I N N E A P O L I S , M IN N E S O T A 55455

December 31, 1965





My Annual Year-end Forecast


Enclosed is a copy of c y annual year-end outlook letter for
the National City Bank of Minneapolis


Necessarily, my forecasts are far more hedged than usual.


On the budget outlook, I have translated the ”$105 to $107
billion” for the fiscal 1966 budget into a $114 billion
guess for fiscal 1967, making clear that it is entirely
a mechanical projection from the 1966 base. How wild
a guess it is, I leave to you.


if e te r
Walter W. Heller


D e t a i l ’. -8 sn

January 1, 1966

W a lter W . H elle r

“ ’Tis the season to be wary” might well be the economic forecaster’s watchword for 1966.
This watchword — quite apart from the drastic changes in outlook and policy that would flow
from sudden peace, or even negotiations, in Vietnam — bears a triple warning of change, uncer­
tainty, and risk:
Change: The rather comfortable prospect of a continued well-paced expansion — with a tax
cut here and a step-up in Great Society, programs there, to provide an economic lift as needed —
has temporarily vanished with Vietnam. Its relentlessly rising demands on the economy have
been the major force in raising prospective GNP for 1966 from $710 billion only six weeks ago
to upwards of $720 billion today. For the first time in our 5-year expansion, the question is
not how hard we need to step on the fiscal-monetary accelerator to speed up our rate
of advance,
but whether, and how hard, we need to step on the fiscal-monetary brakes to keep
our advance within non-inflationary bounds.
Uncertainty: Still uncertain within a fairly wide range are (1) what Vietnam will mean in
budget dollars, (2) what cutbacks will be made in non-Vietnam budget plans, and (3) what
further policy steps will be needed, and taken, to keep demand in non-inflationary balance with
Risk: At his peril, the forecaster must not only predict consumer and investment behavior
but specify his assumptions regarding
Vietnam costs and the associated budget policies
price and productivity advances in an economy which is closing in on its long-sought
“ full-employment potential.”

GN P in 1966: Assumptions and Forecast
Briefly put, the key assumptions underlying my GNP forecast for 1966 are as follows:
• Vietnam costs: Reports of $60 billion military budgets, troop build-ups, and other signs
now point to a rise of $10 to $15 billion in Federal purchases from mid-1965 to late-1966
(the highest of the 3 categories discussed in the September 1 edition of this occasional
i • Budget policy: As explained below, it appears that even the most heroic budget-cutting
efforts cannot keep the fiscal 1967 administrative budget from rising into the $110-$115
billion range. If this is so, further restraint — beyond the Federal Reserve’s recent dis­
count rate increase — would be indicated, and temporary tax increases would become an
ever-present possibility.
• Prices and productivity: Gone are the days (1961-65) when the user of GNP forecasts
could assume that most forecasters were using roughly the same price and productivity
assumptions: a “ GNP price deflator” of about 1%% and annual productivity advances
averaging 3% to 3% % per man-hour in the private sector. For 1966, in an economy oper­
ating at or near potential, judgments will diverge. GNP forecasts will be of little use
* unless they specify their price, productivity, and cost assumptions. The GNP forecasts
I below assume a 2.1% GNP deflator, productivity gains just over 3%, and unit labor costs
\ edging up slightly.



In this setting, and starting with a strong $690 billion rate in the fourth quarter of 1965,
I foresee a $50 billion advance in GNP in 1966:
• G N P would rise from $673 billion in 1965 to $723 billion in 1966.
• This is a rise of 7.4% in dollar terms and 5.2% in real terms.
• The year-to-year rise of $50 billion is $7 billion greater than from 1964 to 1965.
• The fourth-quarter to fourth-quarter rise, however, will be almost the same as in 1965.
The quarterly advances would average about $12% billion, as they did in 1965.
• Under the pressure of Vietnam and plant-and-equipment spending, the advance may be
even stronger in the first than in second half of 1966.
• With this increase in GNP, unemployment will average below 4% for 1966 as a whole,
approaching 3%% by next Summer.
It must be emphasized that this forecast is the end-product of a process which (a) made
the “ iffy” judgment that our economy can deliver a 5.2% advance in real output without push­
ing the GNP deflator up more than about 2% and (b) assumes that overall Federal policy will
exert enough restraint to hold total demand within the forecast bounds.
The tools available to achieve this restraint include such diverse measures as ruthless budgetcutting, graduated income tax withholding, temporary curbs on the 7% investment credit, wageprice guideposts (coupled with appeals for moderation), selective credit restraints, tighter
money, and temporary tax increases. What combination of measures will be applied to keep the
economy on an even keel is not yet clear.



Official projections of a $105-$107 billion range for the fiscal 1966 budget, together with talk
of a $60 billion military budget-to-come, give a surprising amount of guidance on the dimensions
of the fiscal 1967 budget:
• Part of this is at the crude level which suggests that if the budget is rising from $96.5
billion in fiscal 1965 to, say, $106 billion this fiscal year — or nearly $10 billion — a rise
of more than $4 or $5 billion next year is in the cards.
• More convincing is the fact that a $106 billion budget in fiscal 1966 translates into a
sharp climb from a $67 billion rate of Federal purchases in the third quarter of 1965 to
about $75 billion in the second quarter of 1966.
In the absence of official estimates for fiscal 1967, a do-it-yourself approach can start with
this second-quarter level of Federal purchases and either

hold them at the $75 billion level through fiscal 1967, which yields a budget estimate
of $111 to $112 billion, or


raise them by $1 billion per quarter which leads to a budget figure of about $114
billion, or

raise them by $2 billion per quarter, which leads to a budget of $116 to $117 billion.
Uncertainty is the name of the exercise:
• The $106 billion benchmark could move up or down, depending on the demands of war
in Vietnam — or even its cessation — and the speed with which the economy can respond.
• The translation into $75 billion of purchases may not be precise.
• And a $1 billion quarterly add-on may be wide of the mark.
Y et all things considered, the middle assumption seems most plausible. Federal purchases
rising from $73 and $75 billion in the first and second quarters of 1966 to $76 and $77 billion
in the third and fourth, have been used in arriving at the G NP forecast of $723 billion.

Spending increases at the State and local levels will be facilitated by a scheduled strong rise
in Federal grants-in-aid and by rising tax revenues. Borrowing costs for States and municipali­
ties have been rising steadily and will go higher under the tighter monetary environment of 1966.
On balance, a rise of some $5 billion can be expected in State and local government purchases
in 1966.



Plant and Equipment

>3^ ^ /


The most recent Government (Commerce-SEC) survey of busineer fixed,jinvestment pans''boosted previous estimates for late 1965 to a rate of nearly $55 billion and projected further
strong increases for the first half of 1966:
• The survey, taken in late October and early November, projects total plant and equip­
ment spending at an annual rate of nearly $59 billion* in the second quarter of 1966.
• This is 17% above the rate in the second quarter of 1965 and a 38% rise in the nine
quarters after the tax cut.
Since the survey was taken, business borrowing cost's have risen in the wake of the Federal
Reserve’s discount rate increase. Further restraints might be applied, possibly through tempo­
rary tax increases, or still tighter money, or voluntary credit or investment curbs. The net effect
would be to postpone some spending plans into the future. Even with additional restraints, I
expect the 1966 advance in^such spending to approach this yea/s rise of 12%.



Next year, neither a sharp decline in inventory accumulation nor a rush to stockpile should
disrupt the balanced advance of stocks and sales that has marked the entire expansion. The
excess of steel stocks is being worked off faster than most observers expected, both because steel
consumption is currently running ahead of last Summers estimates and because users are willing
to hold more steel as they boost estimates of their own needs for next year. For all of 1966,
inventory accumulation should be near this year’s level. In other words, the rise in GNP will
be a rise in final sales.

Residential construction activity will become a strong expansionary factor before the decade
is over, but not in 1966. Higher interest rates can be expected to spread into the new-mortgage
market and should keep the number of private housing starts in 1966 under 1.5 million.

Consumers’ purchasing power will be buffeted by various cross-currents in 1966. Over the
year, increased payroll taxes will somewhat more than offset new excise tax reductions and
the Medicare payments starting in July. Higher installment interest and possible emergency
taxes would also restrain consumption advances.
But overshadowing these changes will be a rapid expansion of employment and personal
incomes. Personal income in November was $546 billion, $39 billion above the level a year earlier.
A comparable rise is in store by next November. Thio implies an- incrcaac of about $36 billionin diapooablo (after tax) inoomoo in 1066.
Recent surveys of consumer attitudes and buying intentions reveal no let-up in the willing­
ness to spend this additional income. Automobile unit sales should hold their recent pace, and
spending on other durables, on soft goods, and on services will rise nearly in step with incomes.
The rise in consumer spending will account for about 60% of the projected gain in GNP, about
matching last year’s $30 billion increase.

Employment will expand by more than 1.8 million for the year. By the fourth quarter, an
additional 300,000 men will have been added to the armed forces. Total absorption of unemployed
and new entrants will thus be over 2 million in 1966, giving us the tightest labor markets since
the Korean War.
Yet, the overall productivity gains in the private sector should approximate 3%, or a bit
better. With the outlook for wage moderation good in most sectors, unit costs should edge up
only slightly.
And despite another large increase in industrial production, new capacity coming i » line
should roughly keep pace with the expansion of output. Cost and price pressures will be great­
est in construction and service industries.

C O W U U liB R A R Y

On balance, prices will rise slightly faster in 1966 than in 1965. The GNP price deflator can
be expected to increase by a little over 2% next year, with similar increases in the Consumer
Price Index and average industrial wholesale prices. (These price projections assume that excise
tax cuts under the 1965 Act will lower the GNP deflator and CPI by about 0.3%.)
For the sixth consecutive year, corporate profits will rise. We cannot expect the rise to
match the striking advances of $10 billion before taxes and $8 billion after taxes in the 6 quar­
ters since the 1964 tax cut. But a gain of $4 to $6 billion before taxes and $2 to $3 billion after
taxes (less possible tax increases) is implicit in the foregoing numbers.

The year 1966 will sternly test the capacities of the American economy and the responsive­
ness of national economic policy. After nearly five years of expansion, the economy enters this
period of testing in excellent condition:
• It still has not reached its “ rated potential” — with unemployment still hovering above
4% and operating rates in manufacturing averaging 90%, it still has some reserves to
draw on.
• It is still essentially free of the speculation, inventory excesses, cost carelessness, and
wage-price escalation that have led previous expansions into inflation and recession.
• It is still enjoying an accelerating rate of growth in its labor force (which will expand
by 1% million in 1966) and manufacturing capacity (which will expand by nearly 7%
in 1966).
• It is still experiencing nearly stable unit labor costs in manufacturing, where average
hourly compensation is advancing about 3.2% a year, against an estimated 3% annual
rate of productivity growth.
• It is still feeling the cooling breezes of strong international and inter-industry compe­
• Yet, it is still whittling down its balance-of-payments deficit — with the aid of voluntary
restraint practiced by a responsible banking and business community — to a point where
this flank will probably be less exposed in 1966 than in any year since 1957.
So the job of economic policy is to maintain the balanced advance of the economy in the
face of rising pressures rather than the far more difficult one of restoring order to an unbalanced
and inflated economy.
If the pressures build up to levels exeeding the economy’s non-inflationary potential, we
may look for
growing counter-pressure in the form of voluntary restrainteon prices, on wages, per­
haps also on credit and investment, coupled with
severe budgetary discipline
some further tightening of money
some minor tax tightening and, if necessary, application of the logic of the tax cut in
reverse, e.g., in the form of temporary add-ons or surtaxes on corporate and individual
Unless Vietnam escalates far beyond current expectations, direct wage and price controls
will not even be on the policy agenda. Distaste in Washington for the interventionism, the ineffi­
ciencies, and the inequities of wage and price ceilings puts them safely in the “ last resort” cate­
gory where they belong.
What of the halcyon day when fighting in Vietnam ceases? Until negotiations show signs of
succeeding where fighting has failed, the easing of economic pressures will be gradual. Once real
peace is clearly in sight, the stimulus of “ a tax cut here and a step-up in Great Society pro­
grams there” can be applied with skill and speed to make any pause in expansion mild and short.

No part of this report may be reproduced or published without permission of National City Bank
of Minneapolis or Walter W. Heller.

" .............




Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102