You Really Can’t Please Everyone

When economic problems get difficult, Fed-bashing becomes popular. The actions and statements of the Federal Reserve Board chairman are scrutinized and second-guessed not only by the financial community and press, but also by the White House and Congress. Because of this, the ability to take the heat is one of the more important qualities a Fed chairman must have.

Pressure from any or all of these quarters provides a useful safeguard against Fed policies that may occasionally be misguided or inconsistent with the aims of elected officials. Often, however, the Fed is criticized not because it is plainly wrong, foolish or acts contrary to the will of the people, but because others have political motives or are themselves misguided about the economic risks or about what the Fed can accomplish.

There are many dimensions to good economic performance. The Fed has the unenviable task of trying to do well on all counts even though it has only one reliable instrument of policy with which to operate. It can raise or lower short-term interest rates--by adding or removing reserves from the banking system. When it moves interest rates, it will affect the economy in many ways, not all good.

Its most obvious conflict is between goals for real growth of output and employment on the one hand and inflation on the other. Everybody wants strong growth in output and employment. Lower interest rates help promote these goals. But under some circumstances, faster growth brings more inflation--if not now, then down the road a bit--and the Fed always worries about more inflation.

Since 1986, when falling oil prices helped bring inflation as measured by the consumer price index down to only 1%, the inflation rate has been creeping up. At the same time, growth in real output has been brisk, reducing the unemployment rate to near 5%. The Fed has reacted by gradually raising interest rates.

Predictably, some have already been criticizing this Fed policy. Early in the year, there were even hints of a rift between the Fed and the new Administration over it. In estimating the budget deficit for next year, the Bush Administration has projected a strong expansion in the economy together with much lower interest rates. The Fed’s policy would add to the estimated deficit both by producing slower growth and by raising interest expenditures on the national debt. The incipient rift was quickly put to rest by Administration officials, but the issue could reemerge.

Meanwhile, markets and other Fed watchers react to each new straw in the economic wind. Most recently, the economic statistics have become mixed. When the monthly price statistics worsen, as they did when average producer prices recently rose 1% in a month, financial markets react on the assumption that the Fed will raise interest rates. At the same time, critics who fear inflation complain that the Fed has not raised rates soon enough or high enough.

Alternatively, after statistics reveal that the economy is slowing, as they have for the past few weeks, critics begin saying that the Fed has tightened so much that a recession is on the way, and financial markets react on the assumption that interest rates will fall before long.

But financial markets and critics reflect what may be too optimistic a view of what the Fed can accomplish. It may well be that slowing the expansion will still not slow inflation. In most past business cycles, inflation did not ratchet down until the economy went into recession.

Hoping to improve on that experience, the Fed--first under Paul A. Volcker and now under Alan Greenspan--has tried to assure the world that it would allow only as much growth as was consistent with no acceleration of inflation. The idea was to influence the expectations of markets about inflation and, through those expectations, to moderate actual price and wage behavior and so keep inflation from rising. Whether this hope will be fulfilled remains to be seen. But there is as yet no evidence that we have broken the old cyclical link between lower unemployment and higher inflation.

This conflict between spurring output and slowing inflation has only begun to emerge in the present economic cycle. The genuine dilemma for the Fed will come if inflation does not come down even after the economic expansion has slowed and an actual economic recession becomes a clear risk. That may be the situation before the year is over. If it is, the Fed may well see its responsibilities differently than the general public, most politicians and the Administration.

At the start of the decade, Volcker’s Fed caused a massive and prolonged recession in order to stop an inflation that had reached double-digit rates. Criticism of that policy was remarkably muted, largely because inflation was an overriding concern, and the painful medicine was accepted as inevitable. Today, high inflation is a fairly distant memory and there is little appetite for a recession. Indeed, the financial fragility and indebtedness that has built up in banks and corporations over the years of President Ronald Reagan provides added reasons for fearing high interest rates and the recession they would bring.

Today we know that the fear of inflation will loom larger in the Fed’s thinking than in the thinking of politicians or the public at large. Because of that, and despite the costs of recession, the Fed may one day decide that it must raise interest rates much further out of fear that, if it does not, inflation will get continuously, if gradually, worse. That is when the capacity of Chairman Greenspan to take the heat will be sorely tested. And, if it comes to that, it will be hard to render a verdict on whether the Fed is right or wrong. The world may simply offer unattractive choices.