APICS consulting economist Michael K. Evans forecasts a 3 percent growth rate for the U.S. economy through 1997, fueled by consumption and investment in high-tech goods.

By Michael K. Evans

The economy performed better than generally expected in 1996. For the first three quarters of the year, real gross domestic product (GDP) has risen an average of almost 3 percent, although fourth quarter growth will undoubtedly come in below that figure. However, that compares with the consensus estimate -- and my own forecast a year ago -- of around 2 percent. So the question for the 1997 outlook basically boils down to whether the "surprise" element that boosted the economy this year can carry over into next year.

I think it will. The most recent consensus shows real GDP rising about 2 percent next year on a quarterly average basis -- i.e., from 1996.4 through 1997.4 -- but in my view it will be closer to 3 percent.

In 1996, both cars and housing were essentially flat, so that certainly wasn't the area where the economy outperformed expectations. Consumer purchases of nondurables and services didn't rise much either, while net exports fell more than $40 billion.

That doesn't leave much, but the winning sector turns out to be purchases of high-tech goods, both in consumption and investment. Investment in information-processing equipment will rise about 25 percent per year in constant dollars in 1996, while purchases of consumer durables, excluding motor vehicles and parts, will be up about 10 percent. It was realized these sectors would outperform the economy to a certain extent, but the acceleration in growth to 25 percent accounted for almost all of the growth in GDP not expected by forecasters a year ago.

I see no evidence that the high-tech sector will slow down in 1997. Indeed, if the recent surge in high-tech stock prices is any indication of what lies ahead, growth in 1997 could be even higher. However, it isn't necessary to make that extreme assumption to justify our forecast of 2.75 to 3 percent growth for the coming year.

Net exports will continue to decline next year for the simple reason that the U.S. economy is growing much faster than the rest of the G-7 nations and Latin America, which still represent the vast majority of our exports. Inventory investment should be little changed, and it looks like another flat year for housing starts. Excluding high-tech equipment, capital spending should rise about the same 3 percent as it did this year.

However, even if the high-tech sector continues its "double-double digit" gains (i.e., over 20 percent), the growth rate for the overall economy in 1997 will not meet the goal of 3 percent unless consumers loosen their pocketbooks a little more than was the case this year.

According to the official government statistics, consumer spending in constant dollars will rise only about 2 percent this year, well below the expected 3 percent growth in real disposable income. That 3 percent figure consists of a 2 percent rise in employment, a 1.5 percent rise in the real wage rate, minus (c) a 0.5 percent increase in the effective income tax rate.

It's an unusual year when income rises that much more than consumption, but the reason is no mystery. Consumers cut back on their borrowing. After rising at an annual rate of 11.9 percent in the first quarter of this year, the increase in consumer credit dropped abruptly to a 6.4 percent annual rate during the next two quarters, about the same as the growth in personal income.

When we consider that some of that gain in credit represents more people using their credit cards in lieu of cash (i.e., paying their bills without accumulating any interest charges), it seems likely that consumer credit used for time payments fell over the past two quarters. That in turn can be tied to the rise in interest rates during the first half of the year, as well as the fact that many consumers simply reached their borrowing limits.

During the second half of 1996, though, most market interest rates (excluding the Federal funds rate and rates tied to it) declined almost a full percentage point, with further declines expected in early 1997. Hence the rise in interest rates that caused the cutback in consumer credit is already being reversed. In addition, the cutback in discretionary spending, plus the rise in the saving rate over the past two quarters, have given many consumers a much-needed cushion that will enable many of them to start borrowing more again in the near future.


Inflation will remain stable
Inflation is a non-event these days, even though the economy has now been at full employment for more than two years. The core rate for the Consumer Price Index (CPI), excluding food and energy prices, rose 2.5 percent this year and will rise at about the same rate in 1997. For most of 1996, the core rates for the various measures of the Producer Price Index (PPI) -- finished, intermediate, and crude goods -- rose 0.3 percent, fell 1.1 percent and fell 5.3 percent, respectively. No sensible person can make a case for higher inflation based on those numbers.

By the time you are reading this, the current business cycle expansion will be in its 69th month, which sometimes leads to new articles speculating that a downturn must be looming over the horizon. That is forecasting at its worst. Economists may not know how to predict very well, but there is one infallible indicator of recession, and that is the availability of credit, as measured by the shape of the yield curve.

Normally, long-term rates are higher than short-term rates. However, in any year when the curve has been inverted for most or all of the year -- i.e., the short-term rate has moved above the long-term rate -- the U.S. economy has plunged into recession the following year. There are no exceptions. A recession has always followed an inverted yield curve, and there has never been a recession in a year when the yield curve was not inverted the previous year.

With a current normal yield spread between the Aaa corporate bond yield and the Federal funds rate of almost 2 percent, and sufficient credit availability assured for 1997, not only are the chances of a recession next year close to zero, but real growth should actually come in at above-average rates.


Budget deficit should continue to decline
The other remaining item on the economic forecasting agenda is what will happen to the Federal budget deficit. Over the past four years, we have witnessed an unprecedented decline in the deficit from $290 billion to $109 billion. Yet this has been accomplished during a period which, at least by historical standards, represents modest growth.

A quick examination of the figures reveals that, over the past four years, tax receipts have risen about 7.5 percent per year, while spending has risen only slightly more than 3 percent per year. Those growth rates, if continued, would guarantee not only a balanced budget but an actual surplus by 2000. But how realistic is it to assume they will continue; or to put it another way, what sort of flukes led to these figures over the past four years?

For openers, defense spending fell $32 billion over the past four years; it is likely to be flat for the next four. Income security payments rose less than 4 percent per year as the economy returned to full employment; a figure of 6 percent would be a more realistic estimate for the coming term. And the 9 percent annual growth rate in medical care expenditures will clearly be exceeded unless major changes are made in the Medicare and Medicaid laws.

Nonetheless, suppose that figure rises to 12 percent per year, the other changes mentioned above also occur and all other categories of spending rise at the same rate they did over the past four years. Even under that scenario, total expenditures would rise only 5.3 percent per year, reaching a total of $1930 billion in 2000, up from $1570 billion in 1996.

Assuming no recession surfaces for the next four years, which is our working assumption, nominal GDP should climb at the same rate it did over the past four years, or about 5 percent. Of the 7.5 percent annual average gain in tax receipts, about .5 percent was due to the Clinton tax hike. The remaining 2 percent gap reflects two facts: that tax receipts generally rise faster than GDP when the economy is improving; and over the past four years, there has been a further widening of the gap between middle-income workers, whose income rose about 4 percent per year, and upper-income individuals and corporations, whose income rose about 15 percent per year.

Thus tax receipts are expected to rise 7 percent per year for the next four years as well. That would push the figure from $1.46 trillion to $1.914 trillion, which would essentially balance the budget by 2000 -- and would reduce interest rates further.

We have heard so many false promises about deficit reduction over the past 30 years that the goal of a balanced budget may sound like just so much more blarney. In this case, though, we have the track record of a $180 billion reduction over the past four years, so further deficit reduction isn't just pie-in-the-sky promises.

I was admittedly one of the skeptics about whether the original Clinton tax hike would help the economy, but as it turned out, that skepticism was quite unfounded. We have entered the era of the "virtuous circle" in which higher taxes reduce interest rates, hence stimulating capital formation and productivity growth, more than offsetting the negative impact of those higher tax rates. That, in turn, boosts real growth and encourages business optimism to invest more. Unless the Clinton Administration does an abrupt about-face and starts ballooning government spending again, this virtuous circle approach is likely to lead us not only to average or better growth in 1997 and the next three years but the long-awaited goal of a balanced budget by 2000.

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