Crisis Puts the Fed in a No-Win Situation


Saddam Hussein's decision to drive his tanks into Kuwait has suddenly made it much more difficult for the Federal Reserve Board to nudge interest rates lower to help ward off a recession, as the Bush Administration has demanded.

On Tuesday, the Fed's policy-setting Open Market Committee held its first major meeting since the Middle East crisis began, and most outside economists don't believe that the panel decided to move significantly either to ease or tighten its grip on the economy.

In fact, the Middle East crisis has created a Catch-22 for the Fed, making it decidedly more difficult for the central bank to move sharply in any direction as it attempts to set monetary policy for the fall.

If the Fed were to ease its money and credit policies significantly, it could exacerbate inflation, which is already accelerating. If it clamped down to stem inflation in the face of the latest round of oil-price increases, it could tip the economy into a slump.

"There is no question that the Iraq situation has made (Fed Chairman Alan) Greenspan's position much tougher," said Gregory Mankiew, an economist at Harvard University. "Higher oil prices have really worsened the trade-offs that the Fed faces."

That dilemma--and memories of the Fed's mistakes in the mid-1970s, when it chose to ease credit while facing similar

pressures, only to watch inflation soar--presumably dominated Tuesday's regular meeting of the Open Market Committee, which as usual was held behind closed doors.

The committee can ease policy by buying government securities, and thus inject more cash into the economy, or tighten up by selling government securities and reducing the amount of cash that is available.

The Bush Administration has made it clear throughout the summer that it wants the Fed to move to cut interest rates and ease up on the economy.

Even after Iraq's invasion of Kuwait sent oil prices rising, renewing fears of higher inflation and a worsening federal budget deficit, Treasury Secretary Nicholas F. Brady told reporters that he wanted the Fed to ease monetary policy and "tip the scales toward growth."

Treasury officials said Tuesday that those comments by Brady still represent the Administration's position.

Some outside economists believe that if the Fed does not respond to such pressure from the Administration, Greenspan, who is up for reappointment next year, could ultimately be blamed by the Administration for sending the economy into recession.

It isn't clear yet what the open market panel decided Tuesday, but most outside economists familiar with the Fed expect that the committee voted to ignore political pressures and sit tight, waiting for the dust to settle in the Middle East before changing policy.

"They are in a really unenviable position, and so my guess is that they are not going to depart much from where they are right now," said Murray Weidenbaum, director of the Center for the Study of American Business at Washington University in St. Louis and a former chairman of the Council of Economic Advisers.

"I think the only smart thing for them to do right now is wait to see what happens in the Middle East," added William Branson, a Princeton University economist.

The Fed itself is facing conflicting pressures. Although the Administration is pressuring for easier money, Wall Street clearly wants the central bank to concentrate on inflation by holding to its current, relatively restrictive monetary policy.

Any effort to significantly ease credit would almost certainly disrupt the financial community, especially the inflation-sensitive bond market, economists said.

Although the Fed may be able to avoid a misstep for the time being, it will almost certainly be forced to react to the Middle East crisis--and whatever economic consequences it spawns--sometime within the next few weeks.

Although the Open Market Committee is not scheduled to meet again until early October, its members can vote on any policy changes by telephone. The panel held one such conference call after Iraq's invasion of Kuwait, but only for informational purposes, a Fed spokesman said.

In addition, the Fed's board of governors can vote at any time to change the discount rate, the key lending rate that the central bank charges member banks. And they can move to change the federal funds rate, the rate commercial banks charge each other.

Some economists believe that Greenspan and other Fed officials will wait until the publication of the unemployment figures in September to determine whether the economy is sliding rapidly into a recession, and thus is in need of a quick injection of easy credit.

At about the same time, White House and congressional budget negotiators will resume their talks. A sign that the two sides finally are serious about cutting the budget deficit, even in the face of the Middle East crisis, could prompt the Fed to ease its policies, economists believe.

"My personal feeling is that the Fed can't wait much past early September to do something," said David Wyss, a former economist at the Fed and now chief financial economist at DRI-McGraw Hill, a Lexington, Mass. economic forecasting firm.

"But right now," Wyss added, Fed officials "are really facing the worst of all possible worlds."

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