Special Report: The Big Slowdown

By Barbara Rudolph

The words sounded like those of a business leader lecturing the U.S. central bank about the dangers of letting the economy slump too far: "It is prudent for the Federal Reserve to recognize the risk that such softness ((in the economy)) conceivably could accumulate and deepen, resulting in a substantial downturn in activity." Yet the statement came from Fed Chairman Alan Greenspan, who went public with a surprisingly frank assessment last week that, at least for the moment, a recession has replaced inflation as the leading threat to the U.S. economy. In his midyear report to Congress, Greenspan confirmed that since early June, the Fed had been allowing interest rates to fall in an attempt to prevent the sluggishness from becoming too pronounced. Said he: "What we seek to avoid is an unnecessary and destructive recession."

The signals are abundant that the nearly seven-year-old expansion is stagnating. Retail sales are anemic, business inventories are growing, industrial output is shrinking, and the housing industry is struggling. Economists almost uniformly agree that growth during the next year will be very slow, but are divided about whether the U.S. will fall into a recession. The optimists forecast a "soft landing," characterized by minimal growth but no severe dislocation; the pessimists believe the long-running expansion is due for a bona fide recession, with widespread bankruptcies, loan defaults and layoffs.

The Bush Administration last week acknowledged the economy's weakened position when it predicted growth of only 2.7% for the year, down from the Reagan Administration's five-month-old projection of 3.5%. The White House forecasters, looking through the rose-colored glasses favored by most Administration economists, calculate a growth rate of 2.6% for 1990, but a consensus of 52 economists surveyed by the Blue Chip Economic Indicators holds that the economy will grow at a rate of less than 1.5% during the final half of the year and at about the same sluggish pace in 1990. Says Norman Robertson, chief economist at Pittsburgh's Mellon Bank: "The slowdown is now a reality. It has arrived." Two out of three of the Blue Chip forecasters expect that the economy will fall into a recession by sometime next year.

Despite slipping retail sales, most consumers profess relatively little fear about the economy. In a TIME/CNN poll conducted last week by Yankelovich Clancy Shulman, 6 out of 10 adults described current conditions as fairly good or very good, down only a trifle compared with January. Looking ahead to the next twelve months, 72% expected conditions to stay the same or improve, while just 24% of those polled saw the economy getting worse. Asked about their spending plans in the coming year, 65% said they thought it would be a good time to buy a major household item -- a refrigerator, for example, or a television set.

To some extent, however, action belies bravado. Consumer spending, which typically accounts for two-thirds of economic activity and provided most of the oomph for the expansion, is starting to falter. Auto sales have stalled dramatically, contributing to a drop in total retail sales of 0.4% last month and 0.1% in May, the first back-to-back monthly declines since September and October of 1986. Industry is showing the same trend. U.S. factories operated at 83.5% of capacity in June, down from a high of 84.3% in January, a strong indicator that the economy has passed the peak in its current growth cycle.

Despite concerns that the expansion will falter, most economists believe a modest slowdown is necessary to suppress inflation, which had grown particularly stubborn in the past two years. Consumer prices rose at an annual rate of 5.9% during the first half of 1989, up from 4.1% last year. "The economy was running too fast for its own good," says Francis Schott, chief economist for Equitable Life Assurance. "It was working itself up to an inflationary frenzy."

Sensing the inflationary pressures early last year, the Fed tightened credit and dampened growth. In June the Fed was helped in its task by falling energy costs. The Government reported last week that consumer prices last month increased at an annual rate of just 2%, the slowest pace in 16 months. While Greenspan said he sees inflation as a lingering menace, he confirmed that for the moment it has been eclipsed by a need to keep the economy afloat. As a result, interest rates on three-month Treasury bills have fallen from a high of 9.4% in late March to 7.9% last week. The clarity of the Fed's purpose has sent Wall Street on a bullish stampede to post-October 1987-crash highs. Last week the Dow Jones average climbed 53 points, closing at 2607.36.

Economists have been hoping that a modest slowdown would help ease another thorny problem, the U.S. trade deficit, by suppressing the American appetite for imported goods. So far, that has not happened. The Government announced last week that the trade deficit swelled to $10.2 billion in May, up from $8.3 billion in April. Especially troubling was a 4.3% rise in imports, to a record $40.7 billion, which suggested that foreign brand names remain a powerful enticement for U.S. shoppers.

Some economists believe the slack period will be short-lived and will be followed by renewed growth, a scenario that has them searching for metaphors. David Hale, chief economist of Chicago's Kemper Financial Services, characterizes the slowdown as an "output pause." Geoffrey Moore, an economics professor at Columbia University, talks of a "stutter step." Economist Lyle Gramley, a former Fed governor, says that by late 1990 the slowdown may be followed by a period of "economic refreshment."

Some of the optimists expect the expansion to be kept afloat by three major forces: exports, housing and capital spending. No one thinks exports will repeat the explosive growth of last year, when sales abroad jumped nearly 30%, thanks largely to a declining U.S. dollar. One reason U.S. firms should find receptive markets overseas is that the economies of Western Europe and Japan are still rapidly expanding. European Community members are expected to sustain 3% growth in 1989, and Japan is likely to show a 5% gain for the fiscal year ending next March.

For the moment, though, U.S. exports are moving erratically. During the first four months of the year, America's overseas sales grew at a healthy 15% annual rate, but fell 0.9%, to $30.5 billion, in May. Those who predict a soft landing see the one-month reversal as only a temporary setback; others are more troubled. Says Allen Sinai, chief economist of the Boston Co. Economic Advisors: "The trade-deficit report is yet another sign of the potential for a recession sometime within the next six to nine months."

Homebuilding could be another strong foundation for the economy. Real estate usually takes a tumble just before a recession begins and stages a comeback as a recovery takes hold. This time some economists predict that the housing industry, aided by falling mortgage rates, may bounce back later in the year. Last week the Government reported that housing starts during June rose 7%, to an annual rate of 1.4 million. Even so, some experts are cautious about predicting a housing boon because the rise was entirely attributable to an increase in multifamily houses and apartment buildings. There was no growth in single-family-home construction, which forms the largest part of the industry.

While soft-landing scenarios provide reassuring reading, some economists think such forecasts belong on the fiction shelf. If U.S. economic history is any guide, a soft landing is a long shot. That kind of gentle slowdown occurred only once before, in 1967, when the military buildup during the Viet Nam War fueled a demand for capital goods.

If a recession does occur, it may well be triggered by a sharp erosion in consumer confidence. Americans are saddled with hefty debt loads and could easily become jittery if the economy weakens. Says Doris Drury, president of the Center for Business and Economic Forecasting in Denver: "I'm leery of debt. If we could have a recession on the order of 1981 or '82, that could be a real problem." Consumer debt has increased from $1.7 trillion to $3.3 trillion since the expansion began in late 1982. If Americans cut back abruptly on their spending, the effects would ripple through the economy. Businesses would respond to the sales falloff by reducing their own spending and laying off workers, which would spark a further drop in consumer spending.

Deborah Johnson, a senior economist for Prudential-Bache Securities, foresees the possibility of what she dubs a "couch-potato recession." Her scenario: well-off baby boomers, who have already purchased their compact-disc players and microwave ovens and typically have children to provide for, will spend more time at home and do less shopping. According to Prudential-Bache's Yuppie Consumption Index, these consumers cut their spending 2.4% in the period from December through May.

The tremendous buildup of business debt during the long expansion leaves the economy even more exposed to the effects of a recession. Since late 1982, corporate debt has more than doubled, from $1.1 trillion to $2.2 trillion. Investors in junk bonds, the high-yield securities that account for $225 billion in debt, could be among the first to feel the pinch. According to a study conducted for a group of junk-bond issuers by the economic consulting firm Data Resources, 1 out of every 8 will default if the economy falls into a soft landing. A major recession could produce a 1-in-5 default rate over five years. This year some $3 billion worth of junk bonds either have defaulted or were forced into a restructuring. The failure rate is well ahead of last year, when about $4 billion in junk bonds collapsed during the entire twelve months.

In the final analysis, everyone from corporate chieftains to cab drivers realizes that the expansion cannot go on forever. "Someday, some event will end the extraordinary string of economic advances that has prevailed since late 1982," Greenspan told Congress last week. So far, Greenspan has provided a delicate touch in stifling inflation without making the kind of sudden moves that could trigger a recession. The U.S. may be in for only a brief and relatively innocuous reversal like the one in 1961 rather than the painful contraction of 1981-82, when the unemployment rate averaged 8.7%. The current slowdown "is not a good thing, but it's the cost of a good thing," says economist George Stigler, a Nobel laureate and professor at the University of Chicago. Americans can only hope that if they pay now, they can fly again later.

CHART: NOT AVAILABLE

CREDIT: Forecasts by Blue Chip Economic Indicators

Telephone poll of 1,002 adult Americans taken for TIME/CNN on July 18-19 by Yankelovich Clancy Shulman. Sampling error is plus or minus 3%.

TIME Charts by Cynthia Davis

CAPTION: BECALMED

After nearly seven years of expansion, a stagnant U.S. economy could mean that a recession is on the horizon.

With reporting by Gisela Bolte/Washington and Thomas McCarroll/New York