Higher Interest Rates Predicted : Fed Action May Not Be Enough to Curb Inflation
Interest rates, already at their highest levels since 1984, appear headed still higher despite the Bush Administration’s fond hope that the Federal Reserve can tame inflation relatively painlessly, a growing number of economists now believe.
“Once an upward wage-price spiral has been triggered, the only way to reverse it is through recession,” said David Levine, chief economist at Sanford C. Bernstein & Co., a New York investment firm.
While inflation remains comparatively modest, it is now so firmly entrenched in the economy, Levine contended, that a mere slowdown in economic growth will not be enough to bring it down.
The Federal Reserve nudged interest rates up another notch this week in the wake of last Friday’s report of an unexpectedly large 1% jump in January wholesale prices, officials said. The federal funds rate, a key short-term interest rate on inter-bank lending that is closely controlled by the Fed, held at 9.25% Tuesday, up from around 9% over the last few weeks.
At the same time, long-term bond yields crept up again Tuesday, with the 30-year Treasury bond rising to 9.11% from a 9.06% yield late Monday. That left it significantly higher than the 8.91% yield when the government sold bonds to investors last Thursday.
Most analysts, because they do not see a recession in sight this year, are convinced that the latest Fed move will not be the last.
“The Fed does not stop rising prices merely by announcing it is opposed to inflation,” contended David Hale, chief economist at Kemper Financial Services in Chicago. “It has to discipline the system periodically by raising interest rates more rapidly than inflation expectations and, if necessary, threatening to punish it with recession if fine-tuning gestures prove inadequate.”
By raising interest rates, the Fed makes borrowing more expensive and forces consumers and businesses to cut back on their spending, ultimately easing the pressures that push prices up.
Expects Nearly 10% Rate
Hale said that he expects the federal funds rate to rise from 9.25% to nearly 10% later this year. Levine is even more pessimistic, expecting both short-term and long-term interest rates to rise steadily for perhaps as much as two years before finally toppling the economy into a recession.
“Inasmuch as interest rates have risen only a small fraction of the distance necessary to trigger a recession,” Levine wrote in a recent report, “we believe the cyclical increase in both short- and long-term interest rates has a long way to go.”
Because Bush’s budget plan relies on lower interest rates to help bring down the cost of financing the national debt, the Fed’s credit-tightening moves are expected to make it much more difficult for the White House and Congress to reach their $110-billion deficit target next year.
That has the White House worried. In an interview with the Wall Street Journal published Tuesday, President Bush repeated earlier statements urging the Fed to avoid pushing interest rates sharply higher. Bush said that he “wouldn’t like to see” any further credit-tightening by the Fed, adding that he is not “overly concerned about inflation” and considers the recent one-month jump in wholesale prices an “anomaly.”
Fed policy-makers are still taking a cautious approach to monetary policy, hoping to avoid further significant tightening because of worries over widespread problems among savings institutions and the sensitivity of budget negotiations this year.
But analysts remain doubtful that they will be able to avoid a considerable increase. That raises big questions about whether the Administration’s forecast on the economy--which calls for a sharp decline in both interest rates and inflation--can be achieved. The only alternative that would allow rates to come down would be a damaging downturn in the economy, analysts say, which would make the budget deficit worse by sharply slowing down the growth in federal revenues from higher incomes and more jobs.
‘Highly Fanciful’
“The Administration’s interest rate forecast appears highly fanciful,” said Hale. “It is awfully hard to see how the Fed is going to achieve the soft landing it wants.”
Jerry Jordan, chief economist at First Interstate Bank in Los Angeles, said that such a “soft landing” in which inflation and interest rates come down without a recession may be at least “theoretically possible--but the Fed’s tools are not sufficiently precise to make it likely to happen.”
The problem facing Washington policy-makers, he said, is that built-in inflation pressures, although modest by standards of the 1970s, are now working their way through the economy, forcing the Fed to push up interest rates and slow down real growth well before it will have any success in curbing rising prices.
Some economists, however, hold starkly contrary views. “From early 1987 to the present, the money stock has grown at a rate close to 4% per year,” argued John Rutledge in the latest forecast by his Claremont Economics Institute in Southern California. “This kind of money growth will not permit the existence of sustained inflation. . . . Push as they will, rising cost will have a hard time creating inflation in this environment.”
Expects Downtrend
And Alan Reynolds, chief economist at Polyconomics Inc., in Morristown, N.J., said that he believes “inflation should be trending down, not up, bringing interest rates down with it.” He pointed to evidence of relative calm in commodity and gold markets. “Investors are not acting as though they expected higher inflation. There is no rush into tangible assets, such as gold and real estate,” he said.
But Fed officials, according to the recently disclosed minutes of their December policy meeting, agreed that even though “commodity prices appeared to have leveled off, they showed little sign of reversing earlier increases.”
Possible ‘Further Tightening’
Worried that “greater inflation would become embedded in the economy” unless they acted to restrain credit again, Fed policy-makers decided to push interest rates up a notch at that time and agreed to “further tightening at the start of 1989 unless incoming evidence on the behavior of prices, the performance of the economy, or conditions in financial markets differed greatly from current expectations.”
And if anything, Jordan said, expectations have gotten worse since that meeting, not better.
