Top Priority Economically Is Growth

Although the Administration will submit its 1989 budget proposals in a few weeks, it is totally unrealistic in this election year to hope for any significant innovations to reduce the budget deficit. While lowering the deficit remains the most critical issue facing the economy over the years ahead, new legislative progress will have to wait until after the election. That leaves current monetary policy as the key to the health of the economy in both the near term and the more distant future.

Reducing the deficit will inevitably be politically painful, so the only real opportunity to enact the necessary legislation is likely to be in the first half of 1989 while the new President is enjoying his best relations with the Congress and before the anticipation of the 1990 elections destroys all congressional willingness to take unpopular steps. The state of the economy a year from now is therefore critically important.

Although legislating deficit-reduction is politically difficult under the best of circumstances, it would be impossible if the economy were in recession or if a recession appeared likely in the near future. Maintaining the economic expansion is therefore the primary task for economic policy in 1988. And with budget and tax action both on hold until after the election, the Federal Reserve’s monetary policy will be the most powerful influence on the future course of the economy.

Recognizing this link between current monetary policy and the prospects for appropriate deficit action in 1989 resolves the difficult problem of how the Fed should now behave. The policy priority must be to maintain a growing economy.

The risk that such a strategy will raise inflation is unfortunately very real. After five years of expansion, it is perhaps not surprising that inflationary pressures are now appearing in the economy. Several inflation indexes are already showing worrisome increases. The rate of increase of the government’s broadest measure of inflation has risen from 2.3% in 1986 to 3.5% in 1987 and is projected to be more than 4% in 1988. The index of consumer prices shows an even sharper rise from only 1.1% in the year ending December, 1986, to 4.5% in the most recent year. And even if food, energy and shelter are removed from the statistic, consumer price inflation is now running at more than 4%.

The latest unemployment figures showed another decrease in unemployment to 5.7% of the total labor force, a rate that has generally been associated with inflationary wage increases.

The recent upheavals in the financial markets reflected investor awareness of this increased risk of inflation. The Fed cannot ignore the risk of rising inflation if it decides to stay on an expansionary growth path for monetary policy.

But inflation is not the only risk facing the economy and the Federal Reserve. Signs of future weakness in the economy had started appearing even before the stock market crash of Oct. 19 and statistics since then have pointed to a slowing of the expansion in the months ahead. Retail sales have slipped in recent months and housing completions have been declining for several months.

Even the Administration has revised downward its gross national product forecast for 1988, now calling for growth of 2.5%, compared to 1987’s growth of about 3.5%. Others are more pessimistic. The Blue Chip survey of leading private forecasters points to a 2.2% growth rate during the year ahead, barely enough to keep the unemployment rate from rising. A National Association of Business Economists’ poll found that fully one third of its member economists expect recession to set in in 1988 and more than half expect a recession by 1989.

Alan Greenspan and his colleagues at the Federal Reserve must give priority to keeping the expansion going well into 1989 at least. This means increasing the rate of growth of the money stock in line with the targets that the Fed set earlier. The economy could run out of steam if the Fed continues to restrict the increase in the money stock to the slow pace that prevailed in recent months.

There are, of course, those who will criticize Greenspan for an expansionary policy because of the increased risk of rising inflation. Some will accuse him of political motivation, since it is undoubtedly true that a recession in 1988 would hurt Republican chances in November. But the case for a more expansionary monetary policy is economically sound and not politically motivated. Moreover, the best way to eliminate the future inflationary pressures of a runaway budget deficit is to provide the economic environment that makes it possible to enact a budget deficit reduction.

The next President, be he a Republican or a Democrat, needs a grace period with an expanding economy if he is to make the hard budget choices and restore the U.S. economy to long-term health. It would be a tragedy if a weak economy later this year or in the first half of 1989 gave Congress a reason or an excuse to ignore the budget imperatives once again.