VIEWPOINTS : Fed Has to Steer Careful Course to Avoid Shoals

In classical mythology, mariners who sailed the straits of Messina between Italy and Sicily had to navigate very carefully.

Scylla, a barking monster, lived on the Italian side, while Charybdis, who created dangerous whirlpools, inhabited the Sicilian coast. Anyone traversing these waters faced danger on either hand, since neither of these two perils could be evaded without risking the other.

Policy-makers in Washington must feel very much in sympathy with these ancient mariners. For both monetary and fiscal policy appear to be trapped between two evils.

Today’s version of the classical evils is--surprisingly--recession and inflation. If the fiscal and monetary authorities try to avoid one, they may very well bring on the other.

It was not supposed to be this way. After all, inflation was down for the count during most of last year. Indeed, during 1986’s second quarter, prices at the consumer level actually fell.

But that was last year. This year’s inflation story is a lot different. In the first three months of 1987 alone, prices at the consumer level shot up at a rate that would equal 6.2% if carried on for the rest of the year.

Some economists tried to shrug off these price reports, figuring that they were heavily influenced by what was termed “one-shot” jumps in food and energy costs. But these items are so essential that, like garlic bread, they have a way of repeating.

To compound matters, the protracted decline in the foreign exchange value of the dollar against several key currencies--ostensibly to reduce our trade deficit--is adding to inflation as well. Prices of a wide variety of imported merchandise have begun to rise, pulling along with them many domestic goods.

As long as prices of U.S.-made items rise in tandem with foreign goods, we will not only see our trade deficit remain large, we will also see more inflation. And since a large trade deficit means that the goods-producing sector will be unable to increase its sales, a wide swath of American industry will remain in the doldrums--and more downward pressure will be put on the dollar.

Enter the Federal Reserve. During the past 4 1/2 years, by pumping in liquidity at a record rate, our central bank has managed to: (1) lower interest rates; (2) fuel an unprecedented surge in stock prices; (3) pull the U.S. economy out of the 1981-82 recession, and, when it seemed as though the expansion was stalling out because the dollar had soared, (4) depress the dollar.

But the Fed has run into a problem. The decline in the dollar has apparently gone further than the Fed intended.

Chairman Paul A. Volcker is worried about a further drop in the dollar’s foreign exchange value because of its implications for inflation--not to mention the willingness of foreigners to continue investing in our financial markets.

Direct intervention by the Fed and its foreign counterparts does not seem to work, so the only way that the Fed can prop up the dollar, it would seem, is to raise interest rates. Yet, higher interest rates clearly bring on the threat of recession.

On the other hand, some say the Fed ought to ease. They point to the sluggishness of many parts of the U.S. economy, high real interest rates and debt burdens at the consumer, corporate and country levels. Yet lower interest rates could very well prompt a flight out of dollars, causing the U.S. currency to spiral downward.

Plainly, the Fed, like the ancient mariners, is between Scylla and Charybdis. It can neither ease nor tighten.

Fiscal policy is not in much better shape. It is true that the budget remains deeply in deficit and that nearly everyone wants this red ink to be reduced.

But keep in mind that this is the fifth year of economic expansion. By business cycle standards, that makes it a senior citizen, since most upswings don’t even last three years without the “benefit” of war.

Too much budget cutting could easily pull the plug on this expansion. And if a recession occurs for whatever the reason, will Washington try to cushion it by pumping up the deficit? If $200-billion deficits have caused problems for the financial markets, imagine what a $300-billion slug of red ink will do!

Fiscal policy, it seems, is in just as much of a bind as monetary policy. Let’s hope Washington’s policy-makers are good navigators.