'86 outlook uncertain

By Dr. Randall J. Pozdena Senior Economist Federal Reserve Bank of San Francisco

HE ECONOMY in 1985 did not grow at the rate anticipated by administration economists, but was displaying continued moderate strength at the end of the third quarter. What then are the prospects for the economyin 1986?

As usual, the major sources of uncertainty in the outlook for 1986 are government policies, in parti- cular, budget policy and monetary policy. Many economists feel that the current, enlarged federal budget deficit is exaggerating the strength of the U.S. dollar in foreign exchange markets and, thereby, responsible for the trade imbalance and the poor outlook for export-oriented or import-competing industries. Failure to take steps to resolve the federal budget deficit, therefore, will result in continued weakness of affected sectors (including the wood and pulp products industries) and a continued reorientation of our economy toward production of service activities.

Addressing the budget deficit problem by a tax increase is less desirable than an expenditure-cutting approach because the distortions caused by higher rates oftaxation probably would result in a generally weaker economy overall. It is important to note that it is not necessary to balance the budget immediately to effect changes in the exchange rate and the trade balance. Passage of legislation that caused the marketplace to be confident that the budget deficit would be resolved would result in immediate changes in foreign exchange markets which, like debt markets, are highly dependent upon market expectations.

Monetary policy in the last year and a half or so has been stimulative, with some basic measures of the monev supply growing at historically high rates. Conventional monetarist thinking would argue for an increase in the rate of inflation and nominal interest rates within the next ye.u or so. Some economists argue that the extensive deregulation that has occurred in financial markets is such that the economy can't tolerate a high rate of growth in the basic money supply without such an inflationary stimulus. Nevertheless, if such a stimulus continues into 1986, the probability of a return to higher rates of inflation and higher interest rates increases.

It is this author's opinion that the federal budget imbalance is more likely to be addressed by increasing taxation than by expenditure cuts, but that the efforts to address the deficit will not be aggressive. As a result, the dol-

Story at a Glance

Government policies make 1986 uncertain . increased proba. bility of higher inflation and interest rates.. . modest bene. fits from any proposed tax re. lorm . . . housing industry vul. nerable to piecemeal changes.

lar will remain strong in real (that is, price-adjusted) terms. Thus, importcompetitive and export-oriented industries will continue to face weakened demand for their products.

If accompanied by a monetary pollcy that proves overly stimulative, the result would be an ultimately weakening economy, rising nominal interest rates and, hence, weakened demand in the home-building, automobile manufacturing, and other interest-sensitive sectors of the economy.

A final wild card in the process is the proposal to reform the structure ofthe tax system. Although passage of any of the major tax reform proposals ultimately would have beneficial effects on economic activity because of the lower marginal tax rates generally embodied in these proposals, it is this author's view that the proposals would have only modest beneficial effects, but would cause significant short-term (Please turn to page 34)

The opinions expressed are those of the author and do not necessarily reflect the views of the Federal Reserve Bank of fun Froncisco. -ed.