NEWS ANALYSIS : Rate Hikes Deserve Some Credit for an Economic Soft Landing

It was an extraordinary gamble by any standard: hiking interest rates to ward off a threat of inflation that remained invisible to most Americans.

The risk was nothing less than wrecking the long-awaited national recovery. Conducted improperly, the actions of the Federal Reserve Board and its chairman, Alan Greenspan, could have ushered in a new recession or at least derailed the fledgling upturn in California and other hard-hit regions. And even if those problems were avoided, there loomed the danger of a new spiral of inflation.

Now, more than a year later, the Federal Reserve’s high-wire act seems to be working. “I think the Fed--for the time being--can be very pleased with itself,” said Bruce Steinberg, an economist at the Merrill Lynch investment firm in New York.

Indeed, a growing body of evidence makes graphically clear that the interest-rate hikes have chilled what had been a robust national recovery. Last Friday, the Commerce Department reported that economic growth slowed markedly in the first quarter of this year, as consumers pulled back and unsold goods piled up.

On top of that, the news has been filled with unnerving accounts of the dollar’s plunge in global markets and financial havoc in Mexico, further raising the anxiety level.

Yet, odd as it may sound, many analysts believe that slower growth may turn out to be just what the economy’s doctors ordered, not only reducing the threat of inflation but helping prolong the expansion at a sustainable pace.

Robert Parry, president of the Federal Reserve Bank in San Francisco, put it like this: “The evidence to date is supportive of the idea that we’re getting growth to moderate in what I’d say is a desirable way.”

In the jargon of economists, the high-flying U.S. economy is now in descent toward some sort of “landing”--either a sought-after soft landing, characterized by modest growth with little inflation, or a destructive hard landing, marked by growing unemployment. If economists were to vote today, the majority would select the happier scenario.

But, clearly, signs of a chill in growth give most forecasters pause: “Let’s face it--this is the critical point,” said David Wyss, an economist with DRI-McGraw Hill in Lexington, Mass. “You’re starting to see a slowdown, and the only question is whether it will turn into a recession.”

For all its almost mystical stature, the Federal Reserve often has led the nation on a helter-skelter journey of boom and bust.

The historic error was to wait too long as inflation asserted itself before combatting it with steeply higher interest rates and related policies, a cure that typically caused a slump. In one celebrated example in 1980, with inflation soaring beyond 13%, the Fed restricted borrowing. The recession that shortly ensued may have cost Jimmy Carter his presidency. (In that episode, the short-term federal funds interest rate reached nearly 18% a year later--before it, and inflation, began to settle down.)

“The Fed has typically waited too long to tighten. Then they tightened too much,” said Mickey Levy, chief financial economist with NationsBank in New York.

Early last year, the Fed decided there was little time to wait. U.S. economic growth had reached a torrid 6.3% pace in late 1993, and the brisk tempo was continuing into the new year. Consumer inflation remained at bay, around 3%, but fears were rising amid scattered evidence of industrial price hikes.

So on Feb. 4, 1994, the Fed mounted its preemptive strike, boosting short-term rates by one quarter of a percentage point--the first of seven tightenings that would raise short-term interest rates by three percentage points in the course of the next year.

The move sparked an uproar. The Dow Jones industrial average lost nearly 100 points that day, and the bond market began its worst plunge in more than a decade. Many investors were anything but comforted by the attack on inflation.

Rather, they worried that the Fed had uncovered evidence of an emerging, inflationary threat, a fear that forced up long-term interest rates affecting home loans and other borrowing.

In fact, Fed officials were troubled by rising prices for industrial commodities, such as aluminum and lumber, and a falling jobless rate that suggested the economy might soon face disruptive shortages of workers and materials. Typically, inflation flares up late in a recovery, a time when available workers, basic materials and unused factory capacity become increasingly rare--and expensive.

Yet none of this was inside information. Officials were trying a delicate maneuver: to fend off inflationary pressures before price hikes spread broadly through the economy.

“It’s like shooting a gun at a moving target,” observed Allen Sinai, chief economist at Lehman Bros. in New York. The bullet was higher interest rates, which take several months to have a measurable impact on economic activity.

Many economists, including Sinai, applaud the Fed for what they see as an exceptionally vigilant strategy against inflation based on painful lessons from the past.

“People have been trying for years to get them to do something like they’re now doing,” said Allan H. Meltzer, a professor of political economy at Carnegie Mellon University in Pittsburgh. “This is the first, so-far successful attempt.”

The actual research on that point is ambiguous, however, even to the surprise of some Fed officials. A recent study at the San Francisco Fed suggested that the preemptive strike was basically consistent with Fed policies since the 1980s.

“I frankly thought we’d moved earlier and we’d moved more aggressively,” said Parry, the bank’s president, who had supported interest rate hikes when he was a voting member of the Fed’s policy-making Open Market Committee in 1994.

This much is agreed on: The controversial policy has accomplished at least some of its goals.

The core rate of consumer inflation--a gauge of price hikes that screens out the volatile costs of food and energy--dipped below 3% last year, according to the WEFA group of economic forecasters in suburban Philadelphia. Economic growth, meanwhile, rolled forward at a solid 4.1% pace. In short, the economy grew with little inflation, just what officials desired.

But that was last year. Now, the cumulative effect of higher interest rates is taking an obvious economic toll, which has become increasingly noticeable in just the past few days.

Last week, for example, new claims for unemployment benefits jumped to the highest level in four months, reflecting softness in the job market. Last week, the Commerce Department reported that housing starts plunged 8% last month, and the ripple effects are hitting other industries. Sales of furniture and appliances, which had rallied last year, have slipped in 1995, for instance.

Analysts have trimmed earlier, more bullish forecasts for domestic auto sales, reflecting more sober expectations for the economy. For their part, currency traders wonder if the Fed will have to raise interest rates yet again to bolster the dollar by making it more attractive to foreign investors, although analysts view such an action as a last resort.

More importantly, business inventories have been piling up since last year, a quiet development that nonetheless could prompt production cutbacks and consequent layoffs if it continues.

The new report of a slippage in growth between January and March has raised new doubts about the recovery’s staying power, with a minority of economists warning that a more serious slump will develop by next year.

Still, “this is no time for the Fed to panic,” said Laurence H. Meyer, an economic forecaster in St. Louis. The broad picture remains “benign,” he said, adding that in the economy “things don’t happen as smoothly as you like.”

Certainly, the optimists can muster an array of evidence to back up their case. Businesses have continued to invest in equipment, from computers to drill presses, with gains expected in the lofty 13% range this year, according to WEFA projections. Similarly, executives continue to plunk down money for warehouses, factories and other structures, with gains forecast in the 6% to 7% range.

Employment remains high, although payroll job gains have slowed since 1994, and some analysts expect the current pause to be followed by a pickup in growth later this year. The April Blue Chip Economic Indicators survey of forecasters found an average prediction of 3.2% growth this year and 2.2% in 1996--slower rates than in the recent past, but consistent with a lingering recovery.

If their optimism proves warranted, last year’s preemptive strike by the Fed may deserve some of the credit.

“What the Federal Reserve has done is really quite revolutionary,” maintained Sinai. “No other central bank in history would have raised (short-term rates) with inflation being so low.”

Confused by the mishmash of good news and bad? “That’s exactly what happens in a soft landing,” said Ross DeVol, a U.S. economist at the WEFA group.