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Economic Outlook

Last January, the outlook for economic activity and prices appeared more
favorable than it does now.
Prices have risen faster than we expected —
mainly because of large increases in food prices, although not entirely.
Depreciation of the dollar in exchange markets has also worsened the inflation
outlook for 1978, and the underlying rate of inflation may also be creeping
up somewhat because of a faster rise of average wage rates and costs.
Largely
because of the worsening of the price outlook and higher interest rates,
economic activity this year and next will increase somewhat less strongly
than we had earlier expected.
Growth in consumer purchasing power is being
damped by rising prices of food and imported commodities; increasing interest
rates will be taking their toll in reduced homebuilding activity later this
year and on into 1979.
Assumptions Underlying the Base Forecast
Our forecast for this budget exercise takes these developments, as well
as our current fiscal policy assumptions, into account.
The principal assumptions
underlying the forecast are shown in Table 1.
Budget expenditures are assumed to grow at a moderate rate after 1978 —
with increases only a little higher than the rate of inflation.
The rise in
budget expenditures is less rapid than the growth of GNP, so that the ratio
of Federal expenditures to GNP falls to about 21 percent in 1981-82.
The
path of budget expenditures assumed here is consistent with the Administration's
long-term budgetary strategy to reduce the share of Federal expenditures in
GNP to about 21 percent, and to rely on reductions in taxes to spur growth in
the private sector.
Holding to the path of expenditures assumed, however,
implies a very tight rein on spending.







Table 1

Principal Assumptions Underlying the
Base Economic Forecast

I.

Budget Expenditures increase moderately after 1978
Fiscal years
1978

1979

1980

1981

1982

453

500

545

588

638

Increase from previous
year (%)

12.8

10.3

8.9

8.0

8.3

Share of GNP

22.3

22.1

21.7

21.1

20.8

Level

II.

(billions of $)

(%)

Tax reductions are used to maintain economic growth
1.

$20 billion tax cut effective January 1, 1979
$5 billion net reduction for businesses
$ 1

billion reduction in telephone excise tax

$14 billion net reduction for individuals
2.

$15 billion additional tax cut effective October 1, 1980.




-3Table 1 (con't)

III

. Monetary policy remains accommodative
Treasury bill rates increase from about 6-1/2
percent presently to about 7-1/4 percent late
in 1978 and then level off.
Growth in monetary aggregates remains near, and
probably above, the upper end of the Federal
Reserve's current target ranges.

IV.

Anti-inflation policy is moderately successful
Inflation rate is prevented from accelerating,
but does not decelerate.
Prices rise at a 6-1/2 to 7 percent annual rate.

-4-

The forecast assumes a $20 billion tax reduction, effective January 1, 1 9 7 9 ,
in accordance with the agreement worked out last week with Senator Muskie and
Congressman Giaimo.
The distribution of that reduction between individuals
and businesses remains to be worked out with the Congress; we assume for this
exercise a structure of tax cuts broadly similar to that proposed in January.
The forecast also assumes a further tax cut of $15 billion effective
October 1, 1980.
Monetary policy is assumed to remain accommodative.
While interest
rates do rise somewhat further, the increase is not enough to provoke more
than a mild decline in housing starts next year.
The trimming back of the
size of the tax package should make it easier for the Federal Reserve to
stick with an accommodative posture.
The most important factor shaping the
course of monetary policy over the near future, however, will probably be
developments on the price front.
We assume that our anti-inflation policy is moderately successful —
so that inflation does not accelerate materially from the present underlying
rate of around 6-1/2 percent.
If this outcome is to be realized, some
progress will need to be made this year in holding down the rise in prices of
nonfood commodities and services, and moderating the wage settlements for
postal and railroad workers.
Next year, the critical issue will be to achieve
some deceleration in wages and fringes granted in upcoming large union contracts
— teamsters, auto workers, and electrical workers.
Base Economic Forecast
The economic outlook we foresee, given these assumptions, is set forth
in Table 2.
Real GNP would increase by about 4 percent this year and 4-1/4
percent in 1979.
The expansion next year would be led by strongly rising
business fixed investment (7-1/2 percent real grow t h ) . Capital spending
plans are strengthening this spring, and would be given added thrust by the
incentives in the tax package.
Tax reduction would also help to maintain a
steady expansion of consumer spending.




Table
Base Economic Forecast
Economic Results

(Calendar Years)

Real, GNP Growth
(Q4/Q4, Percent)

Unemployment Rate
(Q4 , Percent)

Inflation Rate
(Q4 /Q 4 /Percent)

5.7 to 6.0

4.2

5.6 to 5.9

1980

4.4

5.4 to 5.7

1981

1982

3.7

3.3

5.3 to 5.6

5.4 to 5.7

6.5

6.7

6.8

6.5

7-1/4

7-1/4

7-1/4

7-1/4

7-1/4

(Fiscal Years)

Budget Deficit (-)
or Surplus (+) (billions of $)




4.0

,1979

6.9

3-Month Treasury Bill Rate
(Q4 ,Percent)

Budgetary Results

1978

-57

-56

-43

-27

-8

-6 Forecasts for more than two years ahead are, of course, extremely
hazardous.
Our best guess is that the economy would continue to grow
at somewhat over a 4 percent rate in 1980, as housing starts would be turning
up again, and business capital investment would continue to increase.
Growth
in 1981 and 1982, however, would be expected to slow to about our estimate of
the long-term potential growth rate of real GNP — that is, around 3-1/2
percent.
Since real GNP growth is moderately above the potential growth rate in
1978 through 1980, the unemployment rate would be expected to decline gradually,
to a range around 5-1/2 percent by late 1980.
Thereafter, with economic
growth about equal to potential, unemployment remains about unchanged.
As shown in Table 3, the direct benefits of the recently reduced fiscal
stimulus are not large relative to their direct costs.
Reducing the tax cut
to $20 billion, and postponing its effective date to January 1, 1979, decreases
real GNP by about 0.3 percent by the end of next year, reduces employment
by 150,000, and raises unemployment slightly.
The direct effect on prices is
very small.
The reduced size of the tax cut is not an effective substitute
for other strong anti-inflation measures.
We will still need to work hard to
make the deceleration program effective.
On the other hand, the credibility
of that program will be enhanced by the evidence of fiscal restraint, and the
Fed's task of running monetary policy will be made easier.
Moreover, the risk
of disorderly conditions developing in the foreign exchange markets, or in
money and capital markets, is reduced.
The budgetary results associated with the base economic forecast are
disappointing, even with the smaller tax cut.
The downward revision in our
forecast of economic growth since January has lowered estimated revenues for
fiscal 1978 and 1979, while estimates of expenditures for fiscal 1980 and
beyond have been raised — due partly to the greater inflation and higher
interest rates now assumed.
The deficit in fiscal 1979, even with the
smaller tax cut, is expected to be about $56 billion.
Thereafter, substantial
progress will be made in reducing the deficit, but the budget does not come
into balance even in fiscal 1982.







-7Table 3
Direct Effects of Reducing the Tax Cut
to $20 Billion and Postponing
Effective Datfe to January 1, 1979

Real GNP at the end of 1979 is reduced by 0.3 percent.

Employment at the end of 1979 is reduced by 150,000.

The unemployment rate at the end of 1979 is raised
by 0 . 1 percentage point.
The rate of inflation in 1979 is reduced by 0.1
percentage point.

The Federal budget deficit is reduced by
$ 8

billion in fiscal 1979 and

$2 - 1 / 2

billion in fiscal 1980.

-8-

Reducing the size of the tax cut still further, to $15 billion, would
reduce the deficit in fiscal 1979 by about $3 billion.
Part of the increase
in revenues due to higher tax rates would be lost because of slightly lower
growth in the economy — growth in 1979 would be down to a little under 4
percent, and the unemployment rate would edge up a tenth of a percentage
point.
Another alternative would be to reduce 1980 budget expenditures by
$3 to $5 billion below the $545 level assumed in our forecast.
Major Problems and Uncertainties
There are two principal problems that concern us with the base forecast.
The first is the behavior of unemployment, given our forecast of GNP growth;
the second is the question of whether monetary policy will follow the course
we have assumed.
Unemployment. As we have indicated to you in earlier memos, progress in
reducing unemployment over the past year, and especially over the past six
months, has greatly exceeded our expectations.
Real GNP has grown no faster
than we expected, but the increase in employment and the decline in unemployment
have both been unusually large. Historical relationships between real GNP
and the labor market are simply not holding.




There are three possible explanations for what has happened:
(1)

A temporary aberration has occurred that will be reversed.
If
so, we would be in for a prolonged period in which unemployment
would remain unchanged or rise a little, while real GNP "caught
up" with the prior decline in unemployment.

(2)

Growth in real GNP over the past year or so may have been
underestimated.
If so, we are further along in reaching both
our real growth and unemployment objectives than we realized.
We will therefore need to grow somewhat more slowly in the
future.
While some upward revision in estimated real GNP may
occur in the Commerce Department's regular July revision, it is
unlikely to be large enough to explain the surprisingly large
drop in unemployment over the past year.

- 9 -

(3)

Productivity growth over the past year has been very poor.
This is the most likely explanation of what has happened.
The
implication for the future behavior of unemployment, however,
depends on productivity growth in the future, which remains very
uncertain.

The schematic diagram on an adjoining page may help to illustrate the
problem.
Productivity growth in 1977 and early 1978 was expected to follow
the "normal” line that would put us at point A by the end of 1979.
If it had
done so, the unemployment rate would now be about 7 percent and would gradually
decline to about 6-1/2 percent by the end of next year.
Instead, productivity
growth over the past 5 or 6 quarters has been very weak.
If it continues to
be as weak over the next 6 quarters — that is, if we proceed to point B in
the diagram — the unemployment rate would decline to about 4-1/2 percent by
the end of 1979. This seems to us extremely unlikely.
Based on hunches, and
it i s more of a hunch than a well-documented conclusion, we assume that the
j
very poor productivity experience of the past year is not continued into the
future; on the other hand, we also assume that only a small part of last year's
productivity loss is made up by greater than normal growth next year.
On these
assumptions, we will be back to point C by the end of 1979.
The unemployment
rate would then continue to decline slowly, to a level of around 5-1/2 to 5-3/4
percent late next year.
Our unemployment forecast is thus surrounded with a very large degree of
uncertainty.
If productivity growth is substantially weaker than we have
projected, inflation will become more serious for two reasons:
first, because
unemployment may decline to a level at which wage rate increases begin to
move up strongly; and second, because weaker productivity growth will magnify
the effects of large wage increases on costs and prices.
A good part of the uncertainty we now face may be resolved by developments
over the next 3 to 6 months.
In the interim, our budgetary policy must be
cautious to avoid an inadvertent rekindling of inflationary pressures.
And,
developments may be such as to require even greater stringency later on.







-10Productivity Growth

"Normal Productivity"

W e a k 1977-78
Productivity
Growth

_______ J__________J_________ J______
1976

1977

1978

1979

-1 1 -

Monetary Policy. The second potential problem with the base economic
forecast is the postulated course of monetary p o l i c y . We have assumed that
the Federal Reserve — in response to our reduction of fiscal stimulus —
will continue to pursue an accommodative monetary policy over the next few
months, and that the current rate of price increase does taper off so that
monetary policy is not tightened significantly later on.
In the past, the
Fed has frequently taken on the role of a tough inflation fighter if it
feels that not enough is being done by the Administration to keep prices
under satisfactory control, even when the price increases are of a kind —
e.g., food — which monetary policy affects very little.
Monetary policy is a rather blunt instrument.
There is a substantial
lag between the tightening of monetary policy and its impact on the economy.
While monetary policy itself can be measured out in small parcels — e.g., a
one-eighth to one-fourth percent rise in interest rates — its effects on the
economy are hard to control.
A cumulation of small measures may show no impact for
some time, and then suddenly begin to bite.
If monetary policy tightens much more
than we have assumed, the economy will be weaker in 1979 than we are forecasting, and
there will be little or nothing we can do about it with budgetary p o l i c y .
Pessimistic Economic Forecast
The chances for a considerably tighter monetary policy would increase
greatly if inflation accelerates beyond what we have allowed for in the base
forecast.
We have explored what might happen in this respect by developing
an economic forecast in which the underlying inflation rate rises to the
1 - 1 - 1 / A percent range, and the Federal Reserve lets the interest rate on
Treasury bills move up to around 8 percent by early 1979 (compared with
7-1/4 percent in our base forecast).
The combined effects of more inflation and tighter money would hit the
economy hard (Table 4).
Confidence of businesses and consumers would be
adversely affected, and the continued rise in interest rates would produce
a sharp decline — 2 0 percent or more — in housing starts by the end of next
year.
Real GNP growth in 1979 would drop below 3 percent, signalling a




Table 4
Pessimistic Economic Forecast
Economic Results

(Calendar Years)

Real, GNP Growth
(Q4/Q4, Percent)

Unemployment Rate
(Q4 , Percent)

1978

4.0

5.7 to 6.0

1979

1980

1981

2.7

3.3

4.5

6.0 to 6.3

6.5 to

6.8

6.1 to 6.4

1982
4.2

5.9 to

Inflation Rate
(Q4 / Q 4 /Percent)

7.1

7.3

7.1

6.9

6.7

3-Month Treasury Bill Rate
(Q4 ,Percent)

7-3/4

8

7-1/4

7

7

budgetary Results

(Fiscal Years)

Budget Deficit (-)
or Surplus (+) (billions of $)




-56

-58

-59

-49

-19

6

.

-13-

growth recession, and in that event the unemployment rate would rise
significantly — to as much as 6-1/2 to 6-3/4 percent by the end of 1980.
The increased economic slack would keep the inflation rate from rising still
further, and inflation might begin to moderate by 1981 or 1982, but the costs
of achieving this result would be extremely high.
The deficit would be adversely affected —
billion range in fiscal 1980.

it would still be in the $60

While the pessimistic forecast is not our best guess, its probability
is, unfortunately, too high for comfort.
Should developments over the next
several months proceed along lines that suggest an increasing likelihood of
such an outcome, some further restructuring of monetary and fiscal policies
may be needed.
An outcome like the pessimistic forecast, or worse, will
become nearly inevitable if large union contracts negotiated next year
provide for 9 to 10 percent average annual increases in compensation, as did
the last such contracts signed in 1976.
Optimistic Economic Forecast
We have also investigated the probable outcome of a more successful
effort to obtain deceleration of wages and prices in the private sector.
If
we were to succeed in getting visible deceleration of both wages and prices
beginning this year and continuing into 1979, a momentum would develop that
would augur well for bringing inflation down over the longer run.
In that
event, the Fed would most probably feel able to relax its grip on the monetary
reins, so that interest rates would come down substantially.
The economic
and budgetary results of these assumptions are shown in Table 5.
Economic
growth is stronger, and the unemployment rate is down in the 4-3/4 to 5
percent range by 1982 — in a climate of decelerating inflation.
The budget deficit declines more rapidly than in the base forecast, but
not dramatically so.
However, a large part of the reduced inflation "dividend"
is being taken in stronger economic growth.
Alternatively, more of the
dividend could be taken in the form of better budget performance — by scaling
down, or eliminating, the tax cut assumed for fiscal 1981.




Table 5
Optimistic Economic Forecast
Economic Results

(Calendar Years)

Real, GNP Growth
(Q4/Q4, Percent)

Unemployment Rate
(Q4 , Percent)

1978

4.0

5.7 to 6.0

1979

1980

1981

1982

4.5

4.8

4.2

3.7

5.1 to 5.4

4.8 to 5.1

4.7 to 5.0

5.5 to 5.8

Inflation Rate
(Q4
/Q4, Percent)

6.7

5.9

5.7

3-Month Treasury Bill Rate
(Q4 ,Percent)

7-1/4

6-3/4

6-1/4

Budgetary Results

5.2

(Fiscal Years)

Budget Deficit (-)
or Surplus (+) (billions of $)




5.5

-56

-54

-38

-17

+10

- 1 5 -

The probability of realizing the optimistic forecast is fairly low, but
it is a highly desirable objective at which our anti-inflation program ought
to aim.




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