(FORTUNE Magazine) – Now that recession worries are safely on the back shelf, investors can take a calm look at what moderate economic growth will mean for the year ahead. Inflation will quicken, spurring the Fed to tighten its grip. Interest rates will rebound, creating opportunities for buyers of new debt issues. There's also good news for stockholders, sort of: Operating profits, as opposed to the earnings per share that market watchers often look to, should recover in 1990 to a touch above 1988 levels. The economic growth story: Real GNP will increase around 3% this year over last, a bit better than the 2.6% that FORTUNE forecast a year ago, and it should rise 2% to 2.5% next year. The main growth engines will be a further improvement in trade along with continued increases in business spending for plant and equipment, plus a modest recovery in inventory accumulation. Consumers won't play as lively a tune on the cash registers next year, but they won't clang any sour notes for the economy either. Government spending and housing will show little change. Since the economy will grow a touch slower than the 2.5% to 3% trend expected for the rest of the century, unemployment will inch up to around 5.5%. That's still well below where it was for most of the late Seventies and early Eighties. Those fairly tight labor markets mean that the upward momentum in wages will continue, providing the lift for inflation. For 1989, prices should be up 4.5%, vs. 4% in 1988. Next year the increase should mount to 5.5% or 6%. The good news about corporate profits is qualified. After-tax book profits of U.S. nonfinancial corporations will rise sharply next year. Many investors know that these are generally a less reliable guide to corporate performance than the operating profits measured by the Commerce Department, which exclude inventory profits and write-offs, and use straight-line depreciation on replacement value of the stock of plant and equipment. But the relationship between book and operating profits is changing, making it even harder to judge the value of book profits these days (see chart, next page). In effect, the quality of reported profits is being reduced by the depreciation rules decreed by the 1986 tax reform. Until that year, the Reagan tax relief program had allowed greatly accelerated depreciation, making book profits look much worse than they really were. Now the tables have turned. With the longer service lives required by reform, the depreciation allowed for tax accounting purposes has flattened out, fattening book profits. Meantime, economic, or straight-line, depreciation keeps rising, taking a larger toll of operating profits. In 1985 the excess tax depreciation stood at $57 billion. Next year it will be just $10 billion or so. That $47 billion shift amounts to a 20% cut in this year's pretax profits. And it's hidden, because net profits are being lifted by phantom profits on inventories that have to be replaced at higher prices. Aggregate earnings-per-share figures also paint a rosier picture than operating profits, because they cover only the bigger and more stable corporations. Moreover, companies are writing off losses more slowly, which inflates earnings, and trimming the number of their shares outstanding. As financial officers know all too well, small changes in costs or sales can play havoc with profit estimates. A year ago FORTUNE expected a 10% increase in operating profits for 1989. Instead, they have dropped 8%. Companies raised prices somewhat more cautiously than we foresaw, even though short-term interest rates and unit labor costs climbed more. Let's try again: FORTUNE still expects operating profits to increase 10% in 1990 and net profits to rise 16%. Managers, particularly in manufacturing, will be bolder about raising prices now that capacity utilization is no longer sliding. They have plenty of incentive. For all nonfinancial companies this year, operating cash flow margins (depreciation plus after-tax profits as a percentage of the value of corporate output) are falling to the lowest level since 1974 -- and that was the second worst of the entire postwar period. But stiff competition at home and abroad will limit price increases, so cash flow margins will do well just to hold steady. Next year profits will improve a little more than output, lifting profit margins only a tad. Seekers of instant gratification will find much to admire in corporate dividend policies. Despite the decline in operating profits, dividends on the Commerce Department measure are up a resounding 20% this year. They now represent nearly 80% of domestic operating profits after taxes. Even looking at the ratio of dividends to cash flow, which many executives and financial analysts use to evaluate payouts, the numbers are little better. Dividends account for 22% of cash flow, the highest level in 20 years. Why? Possibly because companies want to boost their stock prices. This may be a return to an old way of life: That dividend-cash flow ratio is as high as it was during the two decades after World War II. But without a surge in cash flow, dividends are not likely to continue growing so rapidly. And those high payouts will do nothing to build competitive strength for the long haul. As for interest rates, which concern investors at least as much as dividends: A slowdown in debt growth will help keep them from rising sharply. The total credit used by all domestic nonfinancial sectors will be about the same as in 1988 -- $766 billion. Borrowing next year probably won't change much either. The growth of debt has fallen from the horrendous 14%-plus pace of 1984 and 1985 to 8.5% this year, and it will edge down to 7.5% or 8% in 1990. One important assumption in our forecast is that Washington will enact some semblance of the compromise on the 1990 budget that Congress and the Administration reached early this year. Since the Administration's forecast of tax revenues and interest rates seems optimistic, the 1990 deficit will turn out well above the Gramm-Rudman target of $100 billion -- probably $135 billion. That will still be a marked improvement from $150 billion in fiscal 1989, not counting the $20 billion the savings and loan bailout will add to federal borrowing in calendar 1989 and again in 1990. Any added federal debt beyond the expected could easily be offset by lower corporate borrowing. True, corporate cash needs will expand next year as outlays for inventories, capital goods, and dividends rise faster than cash flow. But the flood of debt to finance LBOs and mergers doesn't seem likely to continue at the present pace much longer. Last year companies substituted a record $130 billion of debt for stock, and the rate for 1989 looks similar. A decline of only $20 billion in stock retirements during 1990 would counterbalance any rise in normal requirements for new debt. So the pressure on interest rates will come not from borrowing but from the Federal Reserve, nudged toward a gradually more restrictive policy by the prospect of rising prices. Now that the dollar has apparently started on a modest downward trend, the Fed should be able to concentrate on fighting inflation, its No. 1 responsibility as long as no recession threatens. Central bank intervention was the immediate cause of the dollar's decline, but the fundamentals are also pushing it in that direction. The current account deficit is still shrinking -- FORTUNE expects it to drop to $110 billion in 1990 from this year's $120 billion -- but not as fast as it was. The Fed's tightenings late last year and early in 1989 pushed short-term rates up faster than most economists, including FORTUNE's, expected a year ago. It eased up last spring in the face of mounting recession fears, which brought short-term rates down 1.5 to two percentage points by early summer. Since then the Fed has let them climb about half a point, except for Treasury bills, which have held steady. The Fed will likely send all these rates up another point or so by the end of next year, to about the peak levels of March 1989. Corporate bond yields have been behaving counterintuitively recently, and they are likely to keep doing so. They hardly budged as short-term rates rose three points from early last year to early this year. This unusual behavior wiped out most of the spread that separated them from commercial paper. Since the spread is now narrow, you might expect bond yields to rise with the next upswing in short rates. Think again. We are dealing here with multiple levels of expectations. At 9.3%, corporate bond yields are 3.5 to four percentage points above the inflation rate FORTUNE anticipates next year. That spread is nearly a point above the norm. But investors want more of a premium than that over their inflation expectations. We think the extra premium is a hedge against the risk that inflation could get worse than they expect. As inflation heads higher, the Fed will tighten -- and this fatter premium may well shrink. Why? As Alan Greenspan shows that he is relentless about knocking inflation down, investors' worries about a spurt should subside. * So bond yields seem likely to rise with short rates, but probably only half as much. As yields rise, bond prices will fall, bringing potential capital losses for those holding bonds. If you want to get out, in other words, now's the time.

CHART: NOT AVAILABLE CREDIT: NO CREDIT CAPTION: HEADING INTO A HIGHER RANGE Short-term rates, up for the year despite their brief declines in the spring, will rise again next year. Long rates will join them.

CHART: NOT AVAILABLE CREDIT: NO CREDIT CAPTION: WHAT YOU SEE IS NOT WHAT YOU GET Shrunken depreciation allowances are inflating book profits. Operating profits, based on straight-line depreciation, will not recover as much next year.