The outlook for a mature expansion.

All signs point to a modestly good year ahead for the economy. But the Fed will be poised to gently tighten monetary policy, possibly early in the year. All in all, it will be a year of neither boom nor bust.

The economic recovery that began in the spring of 1991 will shortly complete its sixth year. Where is the economy heading in 1997? A good place to begin to answer that question is to think about the major characteristics likely to define the economy's performance.

Employment

In today's economy, the principal defining characteristic is the fact that the economy has reached full employment of its resources. A little slack may be left in the manufacturing sector, where the current rate of capacity use, 82 percent, is a little below the 84 1/2 percent level that prevailed in late 1994. But there can be little doubt that available labor resources are stretched thin. Anecdotes of labor shortages abound, and wage rates have begun to move up in response to a decline in unemployment to around 5 1/4 percent [ILLUSTRATION FOR FIGURE 1 OMITTED]. That is below most estimates of the "natural" rate of unemployment - the rate at which pressures on wage rates begin to build. This implies a threat of somewhat higher costs in 1997. It also means that growth has to slow to the economy's long-term growth potential to avoid a worsening of inflation.

Estimates of the economy's long-term growth potential vary widely; the serious ones, however, range between 2 and 2 1/2 percent. Why so low? Because the size of the labor force is rising by only about 1 percent a year, and growth of productivity is clearly not more than 1 1/2 percent a year. The 2 to 2 1/2 percent range thus sets a practical upper limit to how fast the economy can grow in 1997.

Inflation

A second salient characteristic of the current economic expansion is that inflation, as yet, remains remarkably tranquil. The run-up of producer prices of intermediate goods in 1994 has been reversed, and prices of producer finished goods and consumer prices show no clear signs of worsening inflation. How does one account for this rather remarkable performance of inflation after a long period of economic expansion? Clearly, the world is a less inflationary place than it used to be. I ascribe that to two principal factors. First, global competition keeps American producers on their toes. They cannot afford to let their costs and prices get out of line without risking loss of markets. Second, inflationary expectations have been altered radically by the Federal Reserve's success in bringing down inflation. Businesses, workers and consumers no longer expect prices and wages to begin an upward spiral as soon as the economy emerges from the doldrums of recession. And so they act in ways that help to keep inflation from erupting.

Keep in mind, however, that the basic laws of economics have not been repealed. With wage rates beginning to inch up, an increase in the minimum wage in train, and more pressure on costs likely to develop if the economy's growth exceeds its long-term potential, the threat of moderately higher inflation in 1997 is real. If the Federal Reserve (Fed) is serious about containing inflation, as I believe it is, the monetary policy-makers will have to remain vigilant.

Demand

The third characteristic likely to define the economy's prospects is that, for several reasons, a boom in aggregate demand during 1997 can be pretty much ruled out. Consumers have bought a lot of durable goods in the past several years, and their debt service payments have risen as a share of disposable income. They are not in a position to go on a spending binge.

In the housing industry, backlogs of demand have been filled as housing activity has regained essentially all of the ground lost in the recession of 1990-91. A number of housing indicators - home sales, housing starts and residential building permits - suggest that the housing sector's contribution to growth is about over. Export growth also has slowed, mainly because of weak activity among industrial nations - especially Canada - and the impact of the Mexican financial crisis and its effect on countries in South America. Slower growth in these several sectors has reduced the need for expansion of industrial capacity, and so the growth of business fixed investment has moderated also.

This third characteristic rules out a boom in 1997 but by no means implies excessively slow growth, much less a recession. The typical precursors of recession - rising inflation and spiking interest rates - are not a part of the current scene. Moreover, the economy's overall health, the fourth characteristic I would stress, is remarkably good for an economic expansion soon to head into its seventh year.

For example, nonfinancial corporate profit margins (profits as a share of corporate output) are the highest since the late 1970s. The squeeze on profit margins often seen late in an expansion has not yet begun. Stock prices have been booming in the past couple of years, reflecting a solid base of corporate earnings and an environment of low inflation. Consumers have added to their stocks of durable goods and to their debts, to be sure, but they haven't lost confidence; indeed, confidence levels reported by the two leading consumer surveys are about as high as they ever get [ILLUSTRATION FOR FIGURE 2 OMITTED]. And businesses have kept their inventory positions under good control; the overall ratio of inventories to sales at all manufacturing and trade firms is exceptionally low.

I could go on - banks are once again profitable and well capitalized; credit is flowing rather freely from lenders to borrowers, and the commercial real estate industry has come out of the slump that plagued it for nearly a decade. In short, it is hard to find major cracks in the economy's structure that would predispose it to serious economic weakness in 1997.

Monetary and fiscal policy

Finally, as the last broad characteristic, the stance of monetary and fiscal policy is broadly consistent with continued economic expansion. Monetary policy is widely described as on the restrictive side of neutral, because real interest rates are above historical norms. But what about the other dimensions of monetary policy? In the mortgage market, it is nominal rates that determine the cash affordability of housing to potential buyers, and nominal mortgage rates are a bargain by standards of the past generation. The boom in stock prices has meant wealth creation for households and a cheap source of equity capital to businesses.

The exchange rate is another channel through which monetary policy works; the dollar has gone up a bit in the past year, but it is not yet back to the levels of early 1994, before the Fed began to tighten. One can wall argue, I think, that monetary policy is at least accommodative, if not downright expansionary.

Fiscal policy over the past several years has been fairly restrictive; the deficit has fallen to the lowest level in 15 years or so. Some of this decline has been purely cyclical, but the structural deficit also has been reduced. During the current fiscal year (1997), however, the deficit is scheduled to rise again, so that this source of restraint is now behind us. Thus, nothing in the overall economic policy environment would prevent another year of additional expansion.

I interpret these general characteristics as implying that the economy's growth in 1997 will not depart markedly in either direction from its long-term growth potential. The pertinent question is whether growth will tend to fall short of potential by enough to encourage the Fed to ease monetary policy, or exceed potential by a sufficient amount to require the Fed to raise short-term interest rates. It is a close call, but I am in the latter camp. A review of major sectors of aggregate demand will explain why.

Consumer spending 

The consumer sector is the most critical one. The first half of 1996 was a period of strong increases in consumer spending, particularly for durable goods. Since the middle of 1996, however, consumer purchases of goods in constant dollars have not increased at all. At least that is what the data indicates. Frankly, I think there is something wrong with the numbers, for two reasons. First, retail firms are still hiring quite aggressively - employment in retail trade in the last half year has risen at an annual rate of 3 percent. Why would retail stores continue to add to their work forces if sales were stagnant? Second, if consumer buying were as sluggish as the data currently indicates, retail stores would be awash in excess inventories. But no one is complaining about excess stocks; moreover, orders received by manufacturers are continuing to increase, as is industrial output.

Eventually, I think, the data on retail sales since the middle of 1996 is going to be revised to show a rise in consumer spending more in line with the growth of consumer after-tax incomes. And I expect consumers to continue to increase their spending in line with growth in their disposable income in 1997.

Housing markets

Housing markets were stronger in 1996 than almost anyone had expected. Homes are relatively affordable [ILLUSTRATION FOR FIGURE 3 OMITTED]; consumers are confident, and rising prices of existing homes have made it easier for homeowners to sell their existing homes and move. These facts are well known.

Less well appreciated outside the mortgage lending industry is the fact that competition among mortgage lenders and encouragement from the federal government to make more loans to minorities have led to a relaxation of mortgage terms over the past couple of years, creating opportunities for people at the lower end of the income scale to qualify for loans. Immigration also has been adding to demand for houses in some areas. Accordingly, despite the increase in mortgage rates last spring, applications for mortgage loans to purchase homes remained at a very high level, and recently these applications have risen to new peaks in response to lower mortgage interest rates [ILLUSTRATION FOR FIGURE 4 OMITTED]. These favorable conditions will not soon change. As I said earlier, housing can no longer be counted on as a source of growth. But housing starts are likely to stay on a high plateau unless mortgage interest rates increase above levels prevailing in early January.

I expect business fixed investment this year to rise about 7 percent in real terms on a year-over-year basis, or about the same as in 1996. Orders for nondefense capital goods have picked up a bit since the middle of 1996. Backlogs of unfilled orders in the aircraft industry, moreover, have risen more than 20 percent in the past year.

The outlook for commercial construction also has improved, because vacancy rates for office buildings have come down considerably in recent years [ILLUSTRATION FOR FIGURE 5 OMITTED]. The main thrust to business fixed investment in 1997, however, will come from investment in high-technology items, such as computers and other information-processing equipment. Businesses are still driven by global competition to remain competitive; rising labor costs also will stimulate more capital investment, and businesses have the financial wherewithal to continue investing at a pace well above the probable rise in gross domestic product (GDP).

International trade

International trade is perhaps the sector with the greatest uncertainties. Imports flooded into this country during 1996, leading to a large deterioration in the trade deficit. The rise in imports will no doubt slow in 1997 simply because the overall economy will grow less rapidly. But the course of net exports will not improve unless exports grow more strongly.

A degree of optimism is warranted, it seems to me. Canada, our largest trading partner, is enjoying a pickup in activity stemming from declining interest rates and the effect of a weaker Canadian dollar on Canada's exports. Japan is slowly emerging from a four-year growth recession. So we should see a moderate rise in the growth of our exports to developed countries. For the developing countries, the brightest prospects for improved exports are in Latin America. Mexico is on the mend, and other countries in Latin America have weathered the "tequila effect" generated by the Mexican financial crisis. Argentina and Brazil are well along the path of structural reform and show no signs of turning back. I expect net exports to rise in 1997, but by quite modest amounts.

Interest rate forecast

I add up these pieces and get an overall growth rate in 1997 that, at today's interest rates, would be above the economy's long-term growth potential. With the economy at full employment, that would imply a worsening of inflation that the Fed would not tolerate. Consequently, interest rates will rise by enough to moderate growth to something in the range of 2 to 2 1/2 percent.

I think the Fed will begin to tighten its monetary policies relatively early in the year. The Fed, however, is likely to move slowly and carefully so as not to throw a monkey wrench into a stock market that is very fully priced. The Fed will probably begin by raising both the federal funds rate and the discount rate by 25 basis points, followed by additional tightening actions as they are needed.

However, I do not think sharp increases in interest rates are in the cards during 1997. The economy may grow a little too fast, but it will not boom. Inflation may pick up a little, also, but global competition will remain too strong for an explosion of prices. So, the federal funds rate will probably not rise above 6 percent next year, and the 30-year Treasury bond will probably not go above a range of 7 to 7 1/4 percent. That would imply a contract rate for 30-year, fixed-rate mortgages of around 8 percent to 8 1/4 percent in 1997 - well below the peak levels of 1994.

In this kind of interest rate environment, housing and mortgage banking ought to enjoy a pretty good year in 1997. Demographic factors are not favorable for housing - rates of household formation are comparatively low - so, realistically, housing starts will probably be 6 to 8 percent less than the levels of 1996. Mortgage loan originations will probably fall somewhat, also, but at an estimated $725 billion, total originations will post their fifth-best year in history. And since the mortgage bankers' share of total originations is now solidly above the 50 percent level, efficient mortgage bankers have an opportunity to enjoy a pretty good year.

Where are the risks in this forecast? Risks are certainly on both sides, but I would stress the potential upside risks for growth, inflation and interest rates. I associate upside risks principally with the potential for a considerable strengthening of world economic expansion during the course of 1997. If that happens, it will create increased demand for our exports. It also may lead to shortages of basic industrial materials and, through that route, to higher worldwide inflation. It is not the most likely outcome, but I think it is the one to keep an eye on during the course of 1997.

Lyle E. Gramley is the consulting economist for the Mortgage Bankers Association of America in Washington, D.C.