It’s No Time for a Timid Federal Reserve : Preemptive Strike Against Inflation Makes Sense

“The Federal Reserve’s job is to take away the punch bowl just when the party gets going.”-- William McChesney Martin, chairman of the Federal Reserve Board, 1951-70.

The party’s going just fine. Indeed, it’s time to take away the punch bowl. Since World War II the worst mistakes in economic policy have occurred when prosperity seemed strongest. Modest inflation was allowed to get out of hand. Fighting it then required high unemployment and prolonged economic stagnation. The lesson: A preemptive strike against inflation makes sense.

It’s a lesson worth heeding now. The economic expansion is in its sixth year. Unemployment is at its lowest level since the late 1970s, but inflation is accelerating. Consider the evidence:

--In the past three months the consumer price index has risen at an annual rate of 5.3%, up from 4.4% in 1987. In 1986 big oil-price declines kept the rise to 1.1%. In the previous three years it was just below 4%.

--Wholesale prices, which drive consumer prices, are increasing significantly. Prices for consumer products and business machinery have risen at an annual rate of 5.8% in the past three months. In 1987 the rise was 2.2%. Prices for intermediate goods like steel, plastics and textiles are rising at about a 5.6% annual rate.

--Wage increases are accelerating. Higher labor costs, which are the biggest expense for most companies, could trigger a new wage and price spiral. In 1988 average hourly earnings have risen at an annual rate of 4.2%, compared with 2.7% and 2.0% in 1987 and 1986.

--The drought in the farm belt will worsen inflation. Meat prices will jump the most as producers react to higher grain prices by cutting back. Higher food prices may raise all consumer prices by 0.5 percentage point in 1988 and 0.2 percentage point in 1989, estimates the WEFA Group, a forecasting service.

The Federal Reserve Board can curb inflation by increasing interest rates. Pressures on prices and wages would abate. But the Fed reflects public opinion, and inflation isn’t yet taken seriously.

Precisely the opposite: There is bipartisan complacency. Beryl Sprinkel, chairman of President Reagan’s Council of Economic Advisers, sees little risk of higher inflation. Democrat Michael S. Dukakis barely mentions the subject. Everyone likes good times. In an election year no one wants to contemplate the obvious remedies for higher inflation--an economic slowdown or recession.

It’s a familiar pattern. Since 1960 there have been three rounds of inflationary policies. The Kennedy and Johnson administrations allowed inflation to go from virtually nothing in 1960 to 5.9% by 1970. Under the Nixon Administration the rate rose to 11% in 1974. During the Carter years it peaked at 13.5% in 1980. Almost no one wanted to risk a recession to check inflation. It would be controlled without seriously hurting economic growth.

The Kennedy-Johnson economists argued that they could steer the economy, through changes in budget deficits and interest rates, along a path of “full employment.” Inflation would stay low because there wouldn’t be excessive pressures on wages and prices. When that didn’t work, Nixon imposed wage and price controls. But they merely suppressed inflation and created shortages. Once controls were removed, prices exploded. Carter pretended to deal with inflation through voluntary guidelines.

What ultimately cut inflation were recessions--and the worse the inflation, the worse the recession. Once inflationary psychology takes hold, wages and prices begin chasing each other. There’s a spiral of speculation and anticipation. The faster it goes, the more the Federal Reserve has to raise interest rates to cut the spending and borrowing that propel the spiral. Peak monthly unemployment hit 6.1% after the 1969-70 recession, 9% in the 1974-75 recession and 10.8% in the 1981-82 recession.

Since spring the Federal Reserve Board has reacted to the evidence of higher inflation by increasing short-term interest rates by about 0.75 percentage point. No one knows whether the change will slow the economy sufficiently to reverse inflation’s rise. If it’s not enough, will the Fed do more? Rationalizing delay is easy. Maybe inflation’s increase is only temporary? No one wants to overreact. But delay is dangerous. In the present circumstances an economic slowdown or a modest recession might reduce inflation. But if it creeps upward, getting it down will be a more wrenching process.

Have we learned that lesson? Maybe not.

Even now there are new theories of why inflation can’t get out of hand. The 1970s’ high inflation, it’s said, created automatic defenses by frightening bond investors. At the first signs of higher inflation they seek to protect themselves against the erosion of their money. They demand higher interest rates on long-term bonds and mortgages. The Fed’s influence is mainly on short-term interest rates. By this theory the Fed should simply raise short-term rates when long-term rates increase. Together these changes in interest rates will be just enough to control inflation without stifling growth.

It’s a clever theory--a little too clever. It embodies a charming faith that “the market” can both predict future inflation and prescribe an antidote. Economist Robert Giordano of Goldman Sachs, the investment banking company, points out the theory’s flaw: The market isn’t that farsighted. It represents the collective wisdom of investors who are fallible and given to fads. Their expectations about inflation are often wrong.

Government, not the market, controls inflation. Some price changes occur spontaneously. They result from conditions in specific industries or acts of nature, like a drought. But a persistent rise of prices--that’s what inflation is--happens only when the Federal Reserve creates excessive amounts of money and credit. If inflation continues to rise, it won’t be an accident. It will reflect public indifference and a timid Federal Reserve.