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April 20, 1989
"On Recession's Brink - Storm Clouds Gather on Economic Horizon"
San Jose Mercury News
By Timothy Taylor
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ALL the most recent economic recessions have pursued a similar four-step pattern, and the economy seems to be following in those same footsteps in early 1989. There's no need to head for the storm shelters just yet, but it's certainly time to keep a weather eye on the economic horizon.

In the last few decades, a burst of inflation has been the first harbinger of recession. In the recessions that began in 1974 and 1979, the burst was set off by a surge in oil prices. In the late 1960s, it was the attempt to pay for the war on poverty and the war in Vietnam at the same time.

But whatever the cause, inflation started up, just as it seems to be doing now. In 1986, the Consumer Price Index rose 1.9 percent. In 1987, inflation was 3.6 percent. In 1988, 4.1 percent. In the first two months of 1989, consumer prices were up at a 6.1 percent annual rate and producer prices were up 12.6 percent.

The second step toward recession over the past two decades has been the decision of the Federal Reserve to fight inflation by reducing growth in the money supply. Inflation cuts the purchasing power of a dollar; but by reducing the supply of money, the Fed makes a dollar worth more. Just before the deep recession in 1974, for example, the Fed cut growth in the money supply (measured by what economists call M2) from 13 percent in 1971 and 1972 to just 6 percent in 1973 and 1974.

A similar monetary slowdown is unfolding now. From 1983 to 1986, growth in the money supply averaged 9.5 percent a year. In the last two years, money growth has averaged less than 4.5 percent.

The third symptom of oncoming recession has been higher interest rates. When the Federal Reserve reduces growth in the money supply, it necessarily pushes up interest rates. For example, the Fed may push up the rate it charges banks to borrow. Banks pass along that rise in interest rates to their customers, and the higher interest rates result in less borrowing and less money growth in the economy. During the deep recession of the early 1980s, the prime interest rate soared to 18.9 percent in 1981.

Indeed, interest rates are on their way up. The prime interest rate charged by banks to their best credit risks had fallen from 13.5 percent in mid-1984 to 8.5 percent a year ago. Today, the prime rate is up to 11.5 percent.

The final step is that high interest rates choke off economic growth and the recession arrives as it did in the late 1960s, the mid-1970s, and the early 1980s.

The first industries to feel the pain are usually housing, cars, and other items where the higher interest rates dissuade people from buying. As people buy less and it costs more to borrow, business investment declines. As consumption and investment fall, companies produce less and hire less. The fever of inflation is broken, but at a cost of recession and unemployment.

Although history should not be confused with destiny, this pattern of unfolding recession has a nasty ring of inevitability to it. It's little wonder that business and investors are becoming hypersensitive.

In the Silicon Valley, for example, news stories on the business pages have used phrases like "gnawing fear" and "under pressure" and "ample signs of trouble" to describe the local economic climate. Although the electronics industry has sometimes been able to shelter the county economy from a national recession in the past, it does not seem poised to do so this year. Since last summer, local prognosticators have been predicting a cyclical slowdown in electronics for this year.

While I have been emphasizing the similarities between the current economy and past recession scenarios, there is at least one major difference. In other recent recessions, it took a major event like the fall of Iran, or the OPEC oil embargo, or Vietnam and the war on poverty, to crystalize the economic forces that were already at work.

Barring a similar event, the economy can muddle by with an inflation rate of 5 percent. In fact, the stock market seems to be saying that the increases in interest rates over the past year have been sufficient to halt the rise in inflation.

In the past week, the Department of Labor announced that producer and consumer prices increased at an annual rate of 6.1 percent in March. Although the statistics for any one month can hardly be considered of earth-shattering importance, the stock market went hog wild, responding to the hint that inflation might be topping off. The Dow Jones Industrial Average registered its two highest daily gains in six months.

Even though a recession doesn't seem likely for this year, sitting on the edge of recession is none too comfortable. The Federal Reserve has been walking a tightrope, trying to fight inflation while causing only a slowdown in economic growth, in order to avoid a surge of inflation and a deeper recession in the future. That's a delicate and thankless job, but someone has to do it.

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