(FORTUNE Magazine) – SO YOU THINK a recession is bound to come before the end of next year. The expansion is aging -- it's so ancient it's creaking, you say. Well, think again. We're here to tell you it still has a ways to run. Mind you, the next 18 months will generate plenty of anxiety. Business will have to cope with middling economic growth, flat profit margins, and employees who are increasingly eager to reverse declining real pay. By late 1989 inflation will be rising at its fastest pace in eight years. The Federal Reserve will have to worry about constraining prices just as a tax hit knocks real GNP growth down to a lackluster 2%. But the U.S. trade deficit will continue to shrink. The new President and Congress will finally make the tough budget decisions, probably enacting some kind of consumption tax. Scary as the drought may be, it won't have much effect on the economy as a whole. And unemployment will only inch up from recent lows. No recession is likely until at least 1990. Real GNP growth will seesaw from quarter to quarter, reflecting shifting patterns of economic activity. After increasing at better than a 4% rate since the middle of 1987, it seems to have climbed at only about 2% in the spring. The growth rate may slip lower in the summer as overzealous inventory accumulation subsides. It's likely to climb to 2.5% through the middle of 1989, as the inventory correction ends, before dropping again. Still, because of strong growth in the second half of last year and early this year, the average GNP will be 3.2% higher in 1988 than in 1987. That's about the same gain as in the previous three years. In 1989, with growth slowing, the increase will be a mediocre 2.3%. Industrial production, which sums up the goods-producing portion of the economy, will show better gains. Bolstered by exports that are rising much more rapidly than imports, it will climb nearly 5% this year, a far cry from the 1% to 2% of 1985 and 1986. The improvement next year will moderate to a still respectable 3% as inventory accumulation and demand for final goods simmer down. The economy over the past year or so has outpaced most forecasts. FORTUNE escaped the recession virus that afflicted many economists after stocks crashed. Even so, in our January forecast we underestimated the growth of real GNP this year by what now looks to be 0.9%. Almost all the windfall comes from business purchases of capital goods and inventories. Though profits have been somewhat disappointing, business is committing an above-normal share of its cash flow to capital spending; that didn't seem like plausible behavior six months ago. The leisurely moves to cut the swollen inventory buildup not only reflected confidence about sales prospects but also the fears of rapid inflation that have been so rampant most of this year. Many readers will be skeptical about any forecast without a recession before the end of 1989. After all, last year the expansion became the longest in peacetime of the past 130 years. Before the end of 1989 it will have surpassed the second-longest expansion ever, the 80-month pickup from 1938 to the end of World War II. Only the one sustained by the Vietnam war was longer. But expansions don't deteriorate into recessions just because of old age. Downturns result from excessive spending or some shock, such as a mammoth oil price increase or a clampdown in monetary policy. While you can bet that excess spending will set the stage for recession at some point, that does not seem likely to happen during the next 18 months. The pieces needed to sustain moderate growth are still falling neatly into place. Granted, it all sounds too perfect. As one sector of the economy, say inventories, gets tired, another, such as net exports, comes alive. Yet it's been happening for four years, and the process is continuing. In a paradoxical environment where slow economic growth is good news, one of the things that seem too good to be true is a cooling in the lusty rate of business spending. Recent orders and shipments for capital equipment suggest the surge in the first quarter was a short-lived aberration. Fortune's quarterly survey of inventory policy yields no sign that businesses are planning to build up inventory in advance of price increases, nor that they are about to slash accumulation to eliminate the 1% inventory excess they report.

The November election could have a noticeable impact on the economy in the long run, but in the short run it doesn't make much difference. The most pressing economic issue the new President will face is the 1990 budget deficit. Some sort of tax increase will be needed, along with spending restraint. The best bet is some mix of consumption taxes. They would be less likely to further depress the personal savings rate than an income tax increase -- and might even lift savings a bit by discouraging consumption. We assume that $25 billion of excise taxes will be in place by October 1, 1989, the beginning of fiscal 1990. They could range from gasoline taxes to a low value-added tax. FORTUNE estimates that the federal deficit will hold fairly steady at the $150 billion recorded for fiscal 1987. The deficit for fiscal 1989 will be $20 billion to $25 billion over the target, and any excess beyond $10 billion would require Gramm-Rudman cuts. We are assuming that Washington will paper over the problem in an election year. But when the triumphant guys and gals come back to town and inflation speeds up, Congress will feel increasingly compelled to act. And speed up it will, with the biggest spur coming from paychecks. Increases in total compensation -- wages plus fringes -- have already started to bulge, and by 1989 they will be climbing close to 5.5% a year. Improved productivity will offset only a small part of that. Profit margins aren't likely to add much before the end of 1989, however. Despite rising import prices and the highest capacity utilization since 1980, nonfinancial corporations have not been able to lift their cash flow margins (depreciation plus net profits after taxes) since early 1984. The profits being reported to shareholders and lately dazzling Wall Street (see Money & Markets) are in this hard-nosed view from economists rather illusory. The drought's impact on inflation will be less notable: It will mainly transform the role of food prices from a restraining influence into a goad. It virtually ensures that food prices will climb 5% or so in the year ahead. The major impact will be felt next year when the damage to the corn and soybean crops shows up in meat prices. Price rises in such commodities as copper and aluminum may also add to inflation. But in this era of highly sophisticated manufacturing, basic materials play a smaller role in industrial prices than they used to. More important in an energy-based economy, crude oil prices will probably stay close to today's $17 a barrel. TOWARD THE END of this year the broad-based GNP deflator will likely be rising at nearly a 4.5% annual rate, up from 3.5% in the past few quarters. It will rise to 5% through most of 1989. Consumer prices will climb at a rate of more than 5.5%, driven by higher food and import prices. The consumption tax assumed in our forecast will give inflation a one-time jolt of perhaps two percentage points in the fourth quarter of 1989, but business, consumers, and investors will be fairly well prepared to shrug that off as an aberration rather than the beginning of a new trend. The potential problem is that living standards will take a hit. Since consumer prices will be rising faster than compensation anyway, wages might speed up further in 1990. The dollar looks strong enough to stand the effects of speedier inflation. It has held fairly stable for the past six months despite persistent nail- biting about the state of the U.S. economy. As the post-summit strengthening suggests, that stability should continue. Private foreign investors, who largely stopped buying dollars early in the year, have evidently been returning to the market. Confidence in the dollar should keep rising as the trade deficit shrinks. Measured by the widely publicized Census Bureau data issued each month, the deficit is down to a $150 billion annual rate in the first quarter, a decided improvement from the $170 billion in 1987. The recent report for April, showing a $120 billion rate, may have inspired a little too much confidence; the deficit is more likely to total about $145 billion this year, dropping to $125 billion by the end of 1989. Every prescription for correcting the trade deficit requires domestic demand to climb slowly, making room for increasing exports and damping the demand for imports. That's been basically true since the summer of 1986 and will continue through the end of 1989. Real consumer spending grew an average of only 2% over the past year, down from the 4% to 5% average from 1984 to 1986, and the savings rate climbed from 3% of after-tax income to nearly 4%. For the next four quarters spending will grow only a touch faster. Consumers will throttle back again in the second half of 1989 as they start to take account of the budget-straining excise tax increase we expect. Fed Chairman Alan Greenspan and his board will worry about inflation at 5% to 5.5%, but they are not likely to jam on the brakes. To be sure, the money supply appears to be growing faster than demand so far this year. M2 is expanding at a 7.5% annual rate, well above the 6% of nominal GNP (real growth plus inflation). The pace is near the maximum of the 4% to 8% range targeted for 1988. The Fed may nonetheless be content to let the growth continue the - rest of the year. It will probably tighten its grip next year as inflation accelerates and nominal GNP rises 7.5%, but it will move only gradually. Though there were a lot of other reasons for the crash, the Fed will not soon forget that the debacle came shortly after it raised the discount rate. Nor would it want to add to the effects of budget restraint in a period of subpar growth -- particularly since monetary policy is not especially effective in controlling cost-push inflation from food prices and wages. Interest rates may not change much on balance the rest of this year. The slowdown in the economy will tend to nudge short rates down, while worries over the inflationary effects of commodity prices will nudge long rates up. Next year both will rise, but only slightly. In today's nervous markets, investors in both long and short paper are garnering above-normal premiums over the inflation FORTUNE expects during 1989. It's at least possible these will shrink as the dollar holds steady, the trade gap diminishes, and the federal deficit heads down. The markets can't ignore modestly good news forever. In the meantime, following are the detailed prospects for major sectors of the economy and 15 important industries:

-- FOREIGN TRADE: Striking gains. For the past year and a half or so you had to adjust for inflation to discern that exports were growing faster than imports, but the trend is no longer hidden. In dollar terms the deficit on merchandise trade has finally made its long-awaited turn. Total foreign trade will contribute about a percentage point to GNP, almost as much as it did in the past 18 months. Exporters will increase their volume by 10%, and other businesses will recapture some market share from imports. By the end of 1989 the U.S. deficit on current account will drop to an annual rate of $120 billion from the $160 billion of this year's first quarter.

-- CAPITAL SPENDING: Tooling along. Business will back off from its buying frenzy of early 1988, but sustained domestic and foreign demand will keep real increases in capital goods purchases running at a moderate 2.5% annual rate through the end of 1989. Industrial equipment will deliver most of the torque for the next 18 months, and a spate of orders from airlines will keep planemakers busy. Purchases of computers will keep clicking as vendors tempt companies with better networking systems. Chary of overexpanding, business will build few new plants, and high vacancy rates will keep office construction flat.

-- CONSUMER SPENDING: No frills. Consumers aren't buying the way they used to. Spending advanced by a 1.5% rate during the past 18 months, down from the 1983-86 average of nearly 5%. Desire has not necessarily withered, but incomes have been growing slowly, and consumers have been allocating more to savings, which dipped to a low 2.2% of disposable income just before the stock market crash. Now the rate is back to a respectable 4.5% and likely to stay that high during the next year. Even so, disposable incomes will rise enough for consumers to increase outlays by better than 2%. Staples such as food and services will account for a bigger share of the growth in spending than in the past, when such hot gadgets as CD players and electronic keyboards sparked a 5% increase in appliance purchases. FORTUNE expects that shoppers will pull back by next summer in anticipation of a tax increase before the year ends. That will temporarily slow incomes, outlays, and economic growth.

-- INVENTORIES: Loose reins. Business let stocks build too rapidly in the spring when final sales of goods grew slowly. Now it is gingerly making corrections. This summer car dealers will be getting rid of old models that piled up at about a $7 billion rate. The accumulation of new models will likely just offset the reductions, leaving total inventories unchanged this quarter. Other businesses already trimmed their buildup from the unhealthy 6% annual rate in the first quarter, and will squeeze it further toward a sustainable 3% pace by the end of the year. With sales climbing 4% by the middle of 1989, businesses will be getting rid of the 1% inventory excess they estimated this spring in FORTUNE's quarterly survey. The 3% accumulation rate may exceed the rise in sales a mite in the second half of 1989 if businesses buy ahead to beat price increases.

-- GOVERNMENT BUDGETS: Another bite. It is now clear that the federal deficit will be about the same $150 billion as last year. Changes in the tax code cut more out of receipts than expected and outlays, especially for defense, are running higher than budgeted. What's worse, the deficit won't shrink in fiscal 1989 no matter who next takes up residence in the White House. Defense spending will be pinched, but cuts elsewhere will prove as elusive as ever. (One bonus: The drought, by boosting grain prices, may save a few billion in farm subsidies.) FORTUNE expects a more serious effort to get the deficit heading down for fiscal 1990 -- probably with consumption taxes large enough to raise about $25 billion.

-- WAGES, PRICES, PROFITS: Heading higher. For the first time in the expansion, employers are feeling pressure for significantly higher wages, and the demands will increase. Food prices, which helped to keep inflation moderate until now, are likely to increase by 5% in the next year, and the overall cost of living nearly 6%. By next summer, assuming more normal weather, increases in food prices will abate, and overall consumer inflation will subside to about 5.5%. Despite pay boosts, real hourly compensation, which fell 1.5% over the past two years, will decline another 0.5%. So the clamor for higher pay will continue. Business will be able to recoup the expected rise in labor costs, but profit margins won't give any additional tilt to inflation. With depreciation growing more slowly than sales, after-tax operating profits will nevertheless advance by more than 20% in the next 18 months, vs. only 7% in the last.

-- INTEREST RATES: Ticking up. Though rates had been edging back toward their peaks of last October, they have leveled out recently and won't climb more this year. Corporate bond yields and commercial paper remain a percentage point below the October rates; Treasury bills, which are safer investments and didn't spike as high, are half a point lower. Credit use shouldn't have much effect on interest rates in the period ahead. This year and next, total borrowing by consumers, business, and governments will roughly match 1987's $670 billion, which was already well below the $830 billion of 1986. Though the drought will raise inflation fears this summer, slower economic growth will probably allay them, keeping rates steady on balance. Next year higher inflation and a somewhat tighter Fed policy will tend to nudge rates up. But bond yields, at 10%, are four points above the consumer inflation rate we expect at the end of 1989, a point or so greater than what is considered normal. For commercial paper, the premium is about a half point. These cushions may absorb any upward pressure on rates.

BOX: OVERVIEW

-- Strong industrial output will drive GNP growth.

-- No matter who the President is, consumption taxes are almost inevitable.

-- Wage demands will push inflation higher.

-- The trade gap will keep shrinking, helping to hold the dollar steady.

CHART: NOT AVAILABLE CREDIT: NO CREDIT CAPTION: NO CAPTION. DESCRIPTION: Four charts: Percentage of real Gross National Product (GNP) Growth; inflation level; unemployment rate; operating profits for first and second quarters of 1988 with projections through 1989.

CHART: NOT AVAILABLE CREDIT: NO CREDIT CAPTION: With a bump or two, GNP will advance stolidly through 1989. Industrial output, sparked by strong exports, will climb more rapidly. Net exports are providing the main push. Consumers and business will play supporting roles, with government spending restrained. Inflation's holiday will end with rising wages and prices for food, imports, and -- later -- finished goods. DESCRIPTION: Three charts covering 1980 through June 1988 with projections for 1989 showing comparison of growth in industrial production and real GNP; various GNP components; inflation measured by GNP delfator.