In Holding Steady on Interest Rates, Fed Takes a Big Chance

By deciding against raising interest rates on Tuesday, the Federal Reserve Board might have hoped to answer some burning questions about the economy and inflation. Instead, Chairman Alan Greenspan & Co. just created more questions.

Does the Fed really believe that rising inflationary pressures this year--especially in wages--are nothing to worry about? Or did the central bank governors simply bow to politics, thus avoiding becoming an issue themselves in the presidential race?

Does Greenspan truly expect the economy to slow on its own between now and the end of the year, obviating the need for tighter credit? Or was Greenspan’s main message Tuesday that he won’t be bullied into raising rates, least of all by his own regional Fed bank presidents--whose collective call for higher rates was conveniently leaked to the media last week?

From Wall Street, there was no resounding vote of approval Tuesday for the Fed’s decision to stand pat. Indeed, the markets seemed mildly confused: The Dow Jones industrials rallied 30 points after the Fed adjourned without raising rates, but closed the day with a loss of 20.71 points at 5,874.03.

In the bond market, long-term yields just edged a bit lower. And because bond yields are set more by inflation expectations than anything else, the fact that 30-year Treasury bond yields are stuck around 7%--up from 6% at the start of this year--shows that bond investors fear that higher inflation is in the pipeline.

Of course, the squirrely bond market has gotten the economy’s trend wrong plenty of times over the last few decades. Even so, many economists believe that there is something to worry about, inflation-wise, today.

Average hourly earnings of nonsupervisory workers--the average Joe and Jennifer, in other words--have grown at a 3.4% annualized rate this year, the fastest since 1990. That appears to be a direct result of the tight labor market in many parts of the nation, as companies scramble to attract workers.

Meanwhile, consumer prices have risen at a 3.2% annualized rate this year, up from 2.5% in 1995.

Some analysts say the inflation data has been skewed by higher food and energy prices, jumps that could easily be erased in 1997, depending on what happens with crops and oil prices. “Core” inflation--that is, price increases outside the food and energy sector--remains quite subdued.

The Fed’s defenders say the lack of core price inflation in a strong economy fully justifies the Fed’s restraint with interest rates. “Let the plant bloom” they say about the economy.

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But many of Alan Greenspan’s fellow economists aren’t swayed. They say that all the classic signs of an inflationary buildup are present, and that the Fed should be opting for a “preemptive strike”: raising interest rates modestly to put some drag on the economy and, just as important, to demonstrate that while the central bank doesn’t want to halt wage growth, it surely doesn’t want a dangerous upward spiral to start, either.

“We have ‘full’ employment, the minimum wage is going up and labor unions are not lying down [in negotiations with key industries],” says Sung Won Sohn, economist at Norwest Corp. in Minneapolis. “All of these things are indicative of higher inflation coming, not lower inflation.”

The Fed, Sohn says, could have sent an unambiguous but low-risk anti-inflation signal by raising its key short-term interest rate, the federal funds rate, from 5.25% to 5.5%. Instead, he says, “Politics won over economics” because the Fed didn’t want a rate increase to become a presidential election issue.

Some analysts also believe that politics intruded on another level: Greenspan may have needed to show his regional Fed bank presidents who is boss.

Last week, Reuters news service reported an interesting “leak” purporting that eight of the 12 Fed bank presidents had requested that the Fed’s policymaking committee raise rates to slow the economy and inflationary pressures.

The leak, which the outraged Fed board has reportedly requested the FBI to investigate, was widely viewed as a “bullying” move by the Fed bank presidents, who are known to be far more hawkish on inflation than Greenspan.

Faced with what smells a lot like a mutiny, Greenspan may have felt the need to show that he is the ultimate authority on rates, and that the Fed bank chiefs’ opinions don’t carry as much weight as they had hoped. “This looks like, ‘We’ll show them what their leaks are worth!’ ” says Robert Brusca, economist at Nikko Securities in New York. With Greenspan, he says, “Everything is very personal.”

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And what if the Fed had raised rates on Tuesday? Maybe bond yields would have surged, and stocks would have plunged, because instead of feeling comforted about a vigilant Fed, investors would suddenly have been gripped with paranoia about inflation (i.e., “Does the Fed know something we don’t?”). And the focus might have shifted immediately to the next Fed move: If they raise rates once, they must have more increases in mind, and who knows how high rates might go?

Yet many economists say the focus will soon turn to the next Fed meeting anyway. And the risk now is that if the Fed has waited too long to tighten credit, and the economy accelerates along with inflation over the next two months, the Fed will be viewed as dangerously behind the inflation curve.

Brusca recalls how the Fed’s credit-tightening moves in 1994, as the economy boomed, were put on hold from mid-August through mid-November of that year, at least in part because of election concerns. When the Fed finally acted again, on Nov. 15 of that year, it shocked the stock and bond markets with a three-quarters-of-a-percentage point hike in the fed funds rate, to 5.5%.

Now, as then, “The Fed, instead of raising rates, has crossed its fingers,” Brusca says. Things may well work out better this time, if the economy slows. But if the Fed is late, the pain of steep rate increases later will be worse than whatever hurt might have been incurred Tuesday by a small, preemptive rate hike.

* RATES UNCHANGED

Fed decides to leave interest rates alone. A1

* GOOD NEWS FOR CALIFORNIA

Rate hike could have slowed state’s recovery. D3

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

Higher Inflation?

(Please see newspaper for full chart information)

Average hourly earnings of nonsupervisory workers rose at less than the general inflation rate from 1990 through 1993 and matched inflation in 1994. But this year wages are growing at the fastest pace since 1990--and inflation, too, is edging higher.

1996 (Annualized pace through August)

Price Inflation: 3.2%

Wage growth: 3.4%

Note: Price inflation is change in consumer price index, December-to-December. Wage growth is annual percentage change in average hourly earnings

Source: Labor Department