(FORTUNE Magazine) – IF ANYTHING resembling President Reagan's budget passes, the U.S. will be able to celebrate the Administration's first step toward fiscal restraint. But it will only be a small step--and it is likely to be foreshortened when Congress begins passing the appropriation bills in late summer or fall. By then the economy will have slowed, weakening enthusiasm for spending cuts. Recent economic data have served notice that the recovery--now in its third year--can't be taken for granted. After increasing steadily for 21 months, the widely publicized index of leading indicators has declined in five of the past seven months. Unemployment rose to 7.4% of the civilian labor force in January. Total hours worked leveled out, though they're above the fourth- quarter average. So inflation-adjusted GNP seems headed for 2.5% growth, which FORTUNE forecasts as an average of the four quarters of 1985. Since most of this growth will come from higher productivity rather than new hires, unemployment will rise to 8% by early next year. Don't be misled by the $42-billion drop the published budget shows in the deficit from fiscal 1985 to 1986. Some of Reagan's cuts should be taken with a grain of salt. A good $11 billion of the reduction comes from cuts in funding for the Federal Financing Bank and the Strategic Petroleum Reserve. These haven't been included in the budget in the past, and while the Administration would like to fold them in, Congress has yet to agree. Other transactions also make the decline look bigger than it is. Federal purchases of public housing securities, for example, are soaring to $14 billion this year; they will drop back down to around $2 billion. Such essentially financial transactions are not included in the so-called national-income-accounting budget, which economists regard as the most useful measure for examining the direct impact of federal spending and receipts on the economy. The annual rate of deficit in that budget was $200 billion last quarter--barely below the peak of $211 billion at the worst of the recession in late 1982--and the President's deficit averages only $24 billion less in 1986 than in 1985. By the third quarter of 1986, the Administration projects a deficit of $157 billion. That's still bigger than anything recorded before 1982, and it's optimistic on several counts. The Administration assumes economic growth at an implausible 4% a year throughout the next 18 months; even were that to happen, the economy wouldn't produce as much tax revenue as the Administration expects. On FORTUNE's estimates of slower growth and leaner tax yields, tax revenue in 1986 will be $30 billion or so smaller than Administration predictions. And while inflation-adjusted spending is scheduled to plateau next autumn, Congress will probably add more to social programs than it cuts from defense. So the federal deficit is likely to stay stuck at a rate fairly close to $200 billion well into 1986.

Economists look to the deficit to judge the amount of restraint or stimulus the budget exerts on the economy. The tool they use is the so-called cyclically adjusted budget, which smooths out the effects of the business cycle and clarifies the impact of federal taxes and spending. In the version FORTUNE uses, the economy is assumed to run along smoothly at 6% unemployment (see chart). By this measure, the deficit climbed along with federal spending from around $20 billion a year in early 1981 to nearly $160 billion last quarter. It jumped a notch with each tax cut, and swelled again with the extra surge in spending last year. Based on President Reagan's budget, the cyclically adjusted deficit stays around $155 billion in the first half of 1985 and then drops to $130 billion by the summer of 1986. That confirms the President's good intentions--as well as the limits to what they can accomplish. Federal restraint will be partly offset as state and local governments trim back their surpluses by some $20 billion. The Administration claims these governments are flush, and some could indeed cut taxes. But in general they don't have much leeway. They had to stash away $40 billion of their $50- billion surplus last year for annual funding of employee pensions. By 1986 the state and local govenments will be running in the red because of big spending on public works such as prisons and sewers (though these are legally capital projects, they are included in the national-income accounting). After the brawling dies down this summer, spending by all governments will probably have about the same impact as it does right now. The federal budget will be a hold-the-fort one with no shocks for the economy. To be sure, Treasury credit needs won't bulge as they would have without spending cuts, but they won't wither away either. Interest rates will probably stay at about their recent levels, attracting the investors--particularly from abroad --needed to supply both federal and private credit demands. The deficit problem will move somewhat closer to a solution, but a lot more sweat and tears will be needed to get all the way there.

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