In Fed's Inflation Ambush, Recovery May Get Shot in the Foot

ROBERT EISNER is William R. Kenan professor of economics at Northwestern University in Evanston, Ill. He is the author of "The Misunderstood Economy: What Counts and How to Count It."

It's the economy, stupid! That's what matters to most Americans, but not to our current Federal Reserve Board. For them it's the rate of inflation--or, I should say, their fears, bordering on paranoia, as to what inflation might be.

The Fed's actions of the last two months, culminating in that half-percentage-point increase in short-term interest rates May 17, are risky and wrong. But it is important to understand the premise from which the Fed governors operate--a premise shared by too many others.

It is, simply, that we cannot allow the economy to do too well. Sales must not be too brisk, production too high, growth too rapid or the unemployment rate too low. Otherwise we will have high inflation--indeed, accelerating inflation, inflation going up and up and up.

The inflation rate as measured by the consumer price index was all of 0.1% in April. Productivity has been rising faster than wages, so labor costs have been falling. International and domestic competition are fierce. Yet, because unemployment is all the way down to 6.4%--too low by the Fed's standards--and growth has been slightly ahead of a meager target rate of 2.5%, the Fed sees the economy as "overheating" and in need of cooling off if inflation is to be stopped.

How is the Fed supposed to do this? By raising interest rates, it figures it will reduce borrowing for new houses, consumer durables such as automobiles and business investment.

That's the theory. We can only hope--along with President Clinton, apparently--that the economy is so strong that it won't work. If it does, we will be enjoying fewer new homes and cars and there will be less investment in plants and equipment for our future. And the job losses in the industries most directly affected will spill over to the rest of the economy. The unemployed consumer can't buy much. And the more of them there are, the more all business suffers.

But that's precisely the Fed's idea. We have to make business scramble for sales and keep prices down because of excess capacity. Firms must not bid up wages and other labor costs by trying to hire workers in short supply. That, the Fed says, will stop inflation. But this "cure" for a disease of which we currently have no symptoms may strike many as severe.

There has been another twist on the argument, popular in some Wall Street circles. According to this variant, the Fed--by raising short-term interest rates and showing it means business about fighting inflation--would reduce market expectations of inflation. This, in turn, would depress long-term interest rates, which are related to such expectations.

In fact, interest rates had been falling, with the Fed's encouragement of lower short-term rates, until February. And this had certainly contributed, as intended, to economic recovery. It was precisely when the Fed reversed course, announcing that it was raising short-term rates to combat inflation, that long-term rates went up again.

The faces of many of those Wall Street analysts should be red with embarrassment, for this is just what should have been expected. Whatever anyone thinks about future inflation, long-term interest rates depend on expectations of future short-term rates. By signaling in February that the Fed's priorities had changed--that the governors were no longer keeping rates low to encourage economic growth, but were raising interest rates and were prepared to continue raising them to slow the economy--Fed Chairman Alan Greenspan created a whole new ballgame. Investors now would have to reckon with higher rates into the indefinite future.

Of course, bond prices promptly plunged and long-term interest rates rose.

This can only spell danger for the economy. In advancing his drastic deficit-reduction package, President Clinton looked to low interest rates to compensate for the depressing effects of tight fiscal policy. As long as the Fed was cooperating, this seemed to work. Housing, automobile sales and business investment boomed. The more prosperous economy actually narrowed the deficit more than had been expected. Current forecasts have the 1994 deficit so small that the debt-to-GDP ratio will no longer be growing--fiscal balance, in a relevant economic sense.

Now, though, real reductions in the underlying structural deficit--as opposed to reductions due to a growing economy and low interest rates--are just coming on stream. They will slow the economy themselves. At this point, the Fed adds its monetary restraint and higher interest rates to slow it further.

That may be what the current Federal Reserve Board wants. Do the rest of us?

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