It is easy to misjudge the economy's prospects when things are close to the brink of major change, as current data tell us they are. But having assessed its position through July and into August, and taking account of what can be surmised from such forward-looking data as new order input, contract awards, diffusion indexes, it is clear that things are by no means as bad as overall gross national product expenditures would lead one to believe.
It is essential in this case to look at the components of the total. The gist is that the odds still favor finishing 1986 without recession and moving into 1987 on an updated that is at least moderate but improving.True, there are important negatives in the picture. Two are the feedback onto capital-goods industries of a flat-to-declining trend in manufacturing output and the contractive effect that must be expected from automatic reductions of federal outlays under Gramm-Rudman-Hollings legislation. But there are pluses that should be predominate.
First, except for a sharply reduced accumulation of inventories - an adjustment that should be helpful in the longer term - the two-quarter 1986 GNP growth rate, annualized, would have been 3.8 percent not 0.6 percent. In other words, it would have shown a considerable momentum.Moreover, July figures suggest that the reduction in inventory accumulation may have bottomed out, which would be a strong plus in the second half of the year.
Second, July retail sales figures were poor, but consumer goods output in the GNP accounts has trended up strongly over the past year and in this year's second quarter. This is all the more notable - and favorable for the future - because it did so in the face of reduced monthly increases in consumer installment debt. Also, some strengthening on the consumer side of the economy can be expected from the tax changes in prospect for 1987.
Third, this year's increase in money supply - close to 1 percent for M1 since Feb. 3 - would appear to leave the Federal Reserve little scope for further easing of credit. But it has been indicated for some time and was confirmed by the recent cut in the discount rate that policy would be adjusted in that direction, considering the sluggishness of manufacturing, the favorable inflation prospect and the system's obvious puzzlement over how it should interpret the money supply figures.
Fourth, there should be a supportive effect for home building from lower interest rates and, ultimately, an expansionary effect for export industries
from the lower U.S. dollar.
Finally, for recovery is under way in Western Europe, fairly strongly in West Germany, a plus for U.S. export industries.
It is three months too soon to judge how the economy will react to all of this in 1987, but unless there are further sizable reductions in inventory accumulation, which is unlikely, we will move into next year with the growth rate on an uptrend, always a favorable beginning.
In any event it is a safe guess that we will finish 1986 with the economy growing at least 2.5 percent a year, well above the second-quarter rate, that the rate for the fall year (1986-1985) will be around 2 percent-6 percent and that nominal GNP will be up about 5.4 percent - results close to those projected in earlier versions of these notes.
The implications for financial markets are, first, that interest rates are close to a bottom but, in the near term, are more likely to drop a bit than to rise. As the economy's expansion rate increases there will, of course, be upward pressure on interest rates, especially if there is some speed-up of inflation, which is likely. But the favorable outcome of recent Treasury financing appears to eliminate for the present the risk that rates will be pushed to significantly higher levels by a reduced inflow of funds from abroad.
As for the stock market, the nearterm economic outlook implies a continuation extending into 1987 of disappointing corporate profits, but there is nothing in the prospect to warrant the shake-out of stock prices some have been expecting. At the same time, while the stock market normally leads the economy, and will likely do so this time, prices cannot move up significantly and sustainably until there is more evidence than is presently visible that the economy's next major move will be up.