As the Federal Reserve Takes Aim at Inflation, Analysts Warn of Pain : Economics: Many think that the central bank cannot afford to wait much longer before allowing short-term interest rates to drop.
Has the Federal Reserve squeezed too hard in its attempt to wring inflation out of the economy?
With the consumer price index rising at a pace of almost 5% this year for the first time since 1982, that question may seem to be coming out of left field. But recently, analysts have begun to complain that in pursuing a zero-inflation goal, the central bank is focusing its zeal on the wrong target.
“As a goal, zero inflation is not only wrong, it’s dangerous,” argued John Rutledge, head of Claremont Economics Institute in Claremont. “Given the current breakdown of the CPI, zero inflation would be accomplished with service prices rising at just over 1% per year and manufactured goods prices declining steadily at 3% to 4% per year. This contrived deflation would be a disaster for economic growth.”
Unable to persuade the Fed to lower interest rates and pump more money into the weak economy, the Bush Administration recently jumped on this new bandwagon. At a briefing for reporters last week, Treasury Secretary Nicholas F. Brady essentially echoed Rutledge’s views.
“The Fed’s tools . . . don’t work as well when you get to the area of services,” Brady said. “And whether we should continue to keep the kind of pressure toward keeping inflation under control when you’re aiming only at the service sector of the economy isn’t very clear to us.”
Don’t expect Fed Chairman Alan Greenspan to respond to his critics right away. But indications are that the central bankers are finally taking some of these arguments seriously--and could ease their grip on credit this summer.
Analysts said the Fed’s policy-setting Federal Open Market Committee, which concluded one of its regular two-day meetings here Tuesday, probably has decided to push interest rates slightly lower if the economy shows further signs of weakness.
That move could come as early as next week--if Friday’s Labor Department jobs report suggests that private employment remained stagnant in June. “If we get a bad unemployment report, the Fed should cut interest rates,” said Ira Kaminow, chief economist at Government Research Corp., a private consulting firm.
But a respectable increase of 120,000 to 150,000 jobs would probably induce the Fed to keep the key federal funds rate--the interest that banks charge each other on overnight loans--steady at 8.25%, the level at which it has hovered this year.
“The likely direction of the Fed’s next move will be to ease, and I think that is the way they leaned in the directive (to the Fed’s New York desk, which carries out Fed policies in the credit markets),” said Lyle Gramley, a former Fed governor who is chief economist at Mortgage Bankers Assn. “But they’re going to wait for some more evidence before lowering the funds rate.”
High interest rates are designed to keep inflation in check. Raising the cost of borrowing discourages consumers from buying big-ticket items and makes it more expensive for business to invest in new projects. But a byproduct of that approach is to slow the economy’s upward path, sometimes to the point of causing a stall.
Although few economists see a recession as a result of the Fed’s tight-money approach, many think that the Fed cannot afford to wait much longer before allowing short-term interest rates to drop.
“I know that inflation is still a problem to worry about,” said Steven Axilrod, vice chairman of Nikko Securities in New York and a former top staffer at the Fed, “but with retail sales down three months in a row, the signs of weakness are so clear to me that I think there is room to ease.”
Most other indicators followed by members of the Fed’s Open Market Committee also point in the same direction.
Until the past couple of weeks, for example, the money supply and bank reserves--measures that the monetarists on the Fed monitor closely--had been barely growing. At the same time, in the past three months, wholesale prices have fallen at a 1% annual rate.
Meanwhile, commodity prices, including oil and gold, have turned down in recent few weeks. Federal Reserve Board member Wayne Angell watches those indicators as closely as a nurse monitors the heartbeat of a patient in intensive care.
And the dollar has been relatively strong on international currency markets.
“Practically every indicator any Fed member pays attention to is sending the same signal: It’s time for a gradual, cautious easing,” said Alan Reynolds, head of economic studies at the conservative Hudson Institute in Indianapolis.
But many Fed officials may be reluctant to trim interest rates out of concern that it would be interpreted as bowing to political pressure. Some participants in the political process believe that there should be rate cuts in anticipation of a deficit-reduction agreement.
“The Fed needs to ease for monetary policy reasons, but it can’t afford to be seen as caving in on a political deal” involving budget negotiations between the White House and Congress, said Jerry Jordan, a former Reagan Administration economic adviser who is now chief economist at First Interstate Bank in Los Angeles. “That would send the wrong signal to the financial markets.”
Another factor that has dampened any inclinations by the Fed to lower interest rates is still-stubborn inflation at the consumer level. Excluding the volatile food and energy categories, the consumer price index has crept up slowly, 3.9% at the end of 1986, 4.3% in the fourth quarter of 1988 and 4.6% during the first three months of this year.
“As long as the CPI is on the rise, the Fed has to be extremely careful not to do anything that suggests it might be throwing in the towel (in the fight) against inflation,” said the Mortgage Bankers Assn.’s Gramley.
Nonetheless, many economists are convinced that the Fed can safely ignore the recent rise in the CPI. “The CPI may tell you where inflation was in the past, but it doesn’t tell you where it’s going in the future,” Reynolds contended.
And Rutledge said the Fed should recognize that the large-services component in the CPI gives a distorted picture of the impact of inflation.
“The Fed should abandon its intention to control the CPI and set its inflation targets for goods prices only,” he said. “Since goods prices today are flat or falling, that means it is time for the Fed to back off and let the economy grow again.”
INFLATION: BY THE NUMBERS
While the consumer price index shows inflation to be moderately strong, the producer price index for finished goods indicates that inflation may not be nearly so troublesome.
Consumer price index, percent change from previous year -- May,1990: +4.36%
Producer price index for finished goods, percent change from previous year -- May,1990: +3.06%
Source: Labor Department, Bureau of Labor Statistics.
