As Greenspan Hints at Rate Hike, Some Question Need for Action

The Federal Reserve is about to decide whether to deploy a highly controversial weapon in its economic arsenal--a preemptive strike against an inflation enemy that has yet to appear.

If Fed policymakers vote to raise interest rates at their meeting Tuesday--as Fed Chairman Alan Greenspan has hinted--they will be firing the first salvo in an effort to neutralize an inflation threat that they fear will show up later this year.

Greenspan orchestrated a similar move in 1994 with spectacular success. Not only did he stave off a looming inflation threat, but he also avoided any collateral damage to the economy. The economic expansion that had begun in 1991 continued apace, strengthened by the absence of rising prices and wages.

But 1997 is not 1994. Many analysts contend that an interest-rate increase in the economic environment would put the Fed much further out on a limb than it was three years ago. And some congressmen are expressing fears that the Fed may risk damaging the current economic boom if it raises interest rates prematurely.

Richard B. Berner, chief economist at Mellon Bank in Pittsburgh, notes that there were plenty of blips on the Fed’s radar screen in 1994 to suggest that inflation would soon become a threat. Wholesale prices of raw materials and manufacturing supplies had begun to rise. Strong demand for goods was pushing many factories nearly to their maximum capacity, and some firms were unable to fill their orders on schedule.

This time, there is little to set off the Fed’s alarm bells. Although the economy has continued to grow at a robust rate far longer than anyone expected, it has exhibited none of the bottlenecks of 1994. Pressures for higher wages are scant, despite an extremely low national unemployment rate. Prices are firmly in check.

Greenspan’s apparent embrace of a preemptive strike is based largely on his hunch--one that many other economists share--that the current situation cannot last. If the economy continues to grow this fast, Greenspan argues, inflation pressures will show up later this year, and by then, it will be too late to fend them off.

What is more, most Fed watchers expect that if the central bank does push short-term interest rates up on Tuesday--by, say, a quarter of a percentage point--it will probably be only the opening round in a series of increases that could put rates as much as three-quarters of a percentage point higher by fall.

The Fed’s target for the federal funds rate, which banks charge each other for overnight loans, is now 5.25%. If the Fed does take action Tuesday, it is likely to have an immediate impact on a wide variety of interest rates, from the prime rate that banks charge their best corporate customers to interest rates on credit card balances, consumer loans and even home mortgages.

Despite the concerns of some, most analysts are on Greenspan’s side in assessing the situation. They see more risk to the economy if the Fed does not act--and if inflation regains a foothold--than if policymakers decide to tighten and to push interest rates up.

The economy is now so strong and free of potentially troublesome distortions that a small rise in interest rates is unlikely to dampen growth excessively, they argue.

“Risk of a slump? No, there is none,” said Donald Straszheim, chief economist at Merrill Lynch & Co. in New York.

If anything, the biggest risk might be that higher interest rates in the United States might push the dollar still higher in foreign exchange markets, a move that could worsen the nation’s trade balance but would provide a further hedge against inflation at home.

At the same time, with the Fed’s money and credit policies already reasonably firm, analysts say it will not take as severe a tightening as it did in 1994 for a rise in interest rates to have the desired effect. Three years ago, in steps of one-quarter or one-half of a percentage point at a time, the Fed doubled the federal funds rate from 3% to 6%.

Even so, Robert G. Dederick, an economist at Northern Trust Co. in Chicago, says members of the 12-person Federal Open Market Committee may be hard-pressed to decide whether to back Greenspan’s call for a preemptive strike or to wait until their next meeting in May to take possible action.

Committee members are likely to have to assess, first, whether they expect the economy to continue growing robustly (some analysts anticipate a slowdown, making it unnecessary for the Fed to act) and, second, whether productivity will grow fast enough to lessen the danger.

Then they will have to decide whether, even in a worst-case scenario, they expect wage pressures to mount to where inflation could threaten the current economic prosperity. If the answer is yes, they may act now. If not, they are likely to wait until spring or summer.

That would be too late, Greenspan warns, if inflation looms next fall. Because of the time it takes for economic policy changes to have an impact, the Fed must act now to meet a threat six months away, he says.

With no immediate prospect of inflation, however, raising rates now would not be an easy policy to explain to the public.

Lyle Gramley, chief economist at the Mortgage Bankers’ Assn., cautions that it “is not a foregone conclusion” that Fed policymakers will decide to ratchet rates upward. But Gramley--along with most other Fed watchers--believes that if Greenspan decides to push for such a policy, the Open Market Committee will go along.

The rate increases in 1994 were not the first used by the Fed to counter a perceived threat. In 1983, it tightened credit to ward off future inflation, even though the economy still was in a recession. In 1989, it eased rates to avert a slump, even though inflation still was not defeated.

But David Kelly, senior economist at Primark Decision Economics Inc., argues that the 1994 action was “more clearly a preemptive strike” than the earlier changes, because the Fed openly portrayed it as such. Repeating the maneuver now would make it part of publicly recognized Fed doctrine.

The financial markets are already braced for the first salvo. Greenspan has been laying the groundwork for a rise in interest rates since mid-February. After his latest mention of it--in testimony to Congress on Thursday--yields on 30-year Treasury bonds edged up to nearly 7%, from 6.5% as recently as mid-February.