Strong, Stable Economy Delivers Double Blessing

WASHINGTON —  Friday’s two remarkable economic developments--the lowest unemployment rate in more than 23 years and a bipartisan pact to balance the federal budget--have heightened debate on the key question facing the U.S. economy: Just how long can the present boom continue?

Both the job situation and the budget pact owe much of their success to the same phenomenon. The economy has grown far more rapidly than anyone expected without setting off the kind of inflationary burst that traditionally occurs when labor is in short supply.

The reason for this good news appears to reflect profound changes in the structure of the economy. Global competition and new technology have improved productivity sharply and made job security less certain, enabling employers to hold labor costs down despite the economy’s frenetic pace.

The boom has brought in a flood of unexpected tax revenue that has made closing the budget gap far easier than anyone thought. Some analysts now are predicting that, if nothing goes awry, there could even be a small surplus in the federal budget in 2002.

But the double-barreled blessing could prove short-lived if the economy falters. A new burst of inflation could force the Federal Reserve to raise interest rates more sharply, setting off a recession, increasing unemployment and destroying the budget accord.

While forecasters see no signs of a recession in 1997 or 1998, they are split over the prospect of renewed inflation. The Federal Reserve, seeking to deal inflation a preemptive blow, already has raised interest rates slightly and is expected by many economists to do so again this spring.

The economy’s remarkable performance has intensified debate over how much tighter the labor market can get before it triggers new inflation. Under previously accepted economic theory, the economy should have reached that point when the jobless rate hit 5.3% of the work force.

But the unemployment rate has been at that level or lower since last summer, while inflation actually has abated even further--defying the laws of economics and spawning a new school of economic thinking that holds there is no such limit after all.

“The old rules don’t apply anymore,” said Allen Sinai, chief economist at Primark Decision Economics of New York. “We’re already far below anyone’s estimate of [the trade-off point]. It appears that we are in a new era now.”

But David A. Wyss, a forecaster for DRI/McGraw-Hill in Cambridge, Mass., argues that a limit on noninflationary growth certainly exists, although it probably has shifted a bit in recent years as a result of demographics and other factors.

“The Fed is right--we are seeing the early indicators that inflation pressures are intensifying,” Wyss contended. The economy, he said, is benefiting from special factors that are helping to keep prices low. But that could change, he warned.

Indeed, economists already have changed their estimate of the trade-off point over the years. In the late 1960s, when the concept was developed, analysts argued that the economy’s “full-employment” point, as it was known then, was between 4% and 4.5%.

Over the next 25 years, it gradually was raised as the economy went through its ups and downs, rising to 5%, 5.5%, 6% and, finally, to 6.2%. Only recently was it pushed back down to 5.3%, and even then the rule was not hard and fast.

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George L. Perry, a Brookings Institution economist, argued that the only way economists will know for sure how much lower the unemployment rate can go is to keep “testing the waters,” remaining alert for more signs of new inflation.

The Federal Reserve, he contended, has been doing just that.

Many economists believe that the economy is unlikely to break through that point because the boom is likely to taper off before inflation pressures become too intense. They argue that recent economic statistics have shown that the economy already is beginning to slow.

That in itself would not jeopardize the budget pact because the calculations projecting a balanced budget by 2002 are based on the assumption that the economy will grow at a more “sustainable” pace, say, in the range of 2% to 2.5% a year, down from 5.6% last quarter.

According to fiscal experts, a growth rate of 2% to 2.5% would be fast enough to keep the budget accord intact. The government would not incur sharply higher costs for unemployment benefits and revenue would continue coming in at a high enough level.

In fact, Sinai suggested that, if the economy remains healthy over the next four or five years, the budget plan hammered out by the White House and Congress could prove to be too restrictive and the budget could end up in surplus instead of just in balance by 2002.

Stanley E. Collender, a fiscal expert with the Federal Budgeting Consulting Group, is more stoic about medium-term forecasts. “Anything beyond two years starts to approach science fiction when you’re talking about budget deals,” he cautioned.

In the meantime, Van Doorn Ooms, economist with the nonpartisan Committee for Economic Development and a former White House budget analyst, said that the budget pact is likely to be less vulnerable to economic theory than to Murphy’s Law: Anything that can go wrong usually will.

“Within a couple of years, we will have to revisit this budget agreement, and we will have projections that show significant deficits or even rising deficits,” Ooms said. “This is in a sense a short-run fix.”