Fed Has Its Victory on Inflation; Now, a Tougher Battle

Finally, the last war truly is the last war.

The last war was the Federal Reserve Board’s long battle against inflation--the fight to keep it from resurging and ruining the economic progress the United States has made since 1982.

That war ended in the last three weeks, with the Fed’s quarter-point interest rate cut on Sept. 29, followed by the surprise cut of another quarter-point last Thursday.

After years of preaching about the need for armed response against an inflation enemy that many Fed critics said was a figment of the central bank’s imagination, the Fed has hastily declared victory--and has wheeled the cannons around to take aim at what its critics say was the real enemy all along, namely the specter of global deflation and depression.

Now, no more listening to Fed governors drone on about the need for vigilance--and tight money--even though the inflation rate has dwindled from 3.3% in 1996 to 1.7% in 1997 and a mere 1.4% annual pace so far in ’98.

Likewise, no more listening to exasperated Fed critics complain that “they’re still fighting the last war,” evoking images of Fed chief Alan Greenspan patrolling Wall Street in a World War I doughboy uniform.

By cutting interest rates and pumping money into what is still a healthy U.S. economy overall, the Fed is putting aside all reservations and is voting for faster growth. And if higher inflation ultimately is a byproduct of this paradigm shift--the old Fed worry--well, as Scarlett said, “I’ll think about [that] tomorrow.”

The recent history of inflation, and the Fed’s actions, might be helpful here: Inflation, as measured by the consumer price index, peaked at more than 13% in 1980, the bad old days of sky-high oil prices and tight commodity supplies in general. Inflation then came down quickly by the mid-1980s (helped by collapsing oil prices), but by the late ‘80s was again creeping higher, toward a 6% rate.

The Fed crushed that trend by jacking up interest rates in 1988 and 1989. The Fed’s unwitting partner in that anti-inflation, anti-economic-growth campaign was Saddam Hussein, who helped trigger global recession in 1990 by sending Iraqi troops into Kuwait.

To get the economy growing again--and, equally important, to save the devastated U.S. banking system from its 1980s overhang of bad loans--the Fed intelligently opted to keep short-term interest rates extraordinarily low in 1992 and 1993. The so-called federal funds rate, the overnight loan rate among banks, was just 3% in those days, compared with the current 5% rate (which the Fed has cut from 5.5% since Sept. 29).

But by 1994, with the banking system saved, the Fed went back into anti-growth, anti-inflation mode in a major way: It doubled the federal funds rate over the course of a year. And since 1995, even as inflation has continued to drift lower, the Fed has kept credit in the economy tighter than many analysts believe was necessary.

The argument of those who wanted looser credit was that the Fed didn’t understand the “new” economy. Fed critics said that intense global competition among goods and services providers, as well as productivity gains generated by the surge in high-tech equipment investment, meant the economy could easily sustain a faster growth rate than in the past without producing higher inflation.

Companies, the argument went, either simply had no pricing power or had no need to raise prices, because, with productivity gains, they could make more with less.

To his credit, Greenspan talked a lot about the possibility that this was true. But the Fed nonetheless kept a brake on the economy’s pace (though, of course, it still grew).

Even amid the collapse of East Asia’s economy over the last year, the Fed seemed convinced that the greater risk to the world was resurgent inflation rather than the deflation/depression scenario painted by worried analysts.

If the Fed was going to have a St. Paul-like conversion, it was obviously going to take something big. And something very big is exactly what came along: Russia’s plunge into a financial abyss in August; the subsequent threat that Latin America could go next; and, finally, the spread of the global “credit crunch” to the United States.

The Fed’s harshest critics believe its performance has been shameful. Why, they ask, would the Fed wait so long to begin easing credit when the risks clearly were growing that the global economy could face Japan’s sad fate since 1990: falling prices, crashing markets, and the paralysis of its banking system and credit markets as investors fled in panic.

“Greenspan had to be hit in the face before he woke up,” says Scott Grannis, economist at Western Asset Management in Pasadena.

Bruce Steinberg, economist at Merrill Lynch & Co., sees it differently: “Greenspan had to get the rest of the Fed [governors] on board” in terms of understanding the severity of the problem, he says.

Now, with so many U.S. and global investors still seemingly petrified to take risks--all but shutting down the capital markets and thus drying up the money and credit that many U.S. and foreign companies need to keep their businesses functioning--the Fed, by cutting interest rates, is finally in full attack on the forces of deflation and depression.

Saving the U.S. banking system in 1992 and 1993 was a straightforward task. The Fed, by keeping the economy’s key short-term interest rate at 3% in those years, allowed banks to engage in a profitable “carry trade”: They borrowed at 3% to buy Treasury bonds paying 5% or more. The spread between those rates was banks’ profit, which rebuilt their balance sheets.

Today, restoring confidence to capital markets worldwide arguably will be a tougher feat for the Fed. For one, there is as yet no carry trade: With the federal funds rate still at 5%, while Treasury securities of every maturity yield less than that, there is no easy profit spread for Wall Street.

What the market is saying, of course, is that the Fed must cut rates drastically--lowering the fed funds rate to at least 4%, and probably below that, by mid-’99.

“Rates need to be low enough that commercial banks and investment banks can feel confident again they can make money at what they’re doing,” namely taking risks, says Steinberg.

So the last war is finally over--or at least on hold. But does the Fed, by opening the money flood gates, now risk eventually stoking the very inflation that it long sought to suppress? That may take a couple of years to know.

In any case, history has shown that combating inflation is a far easier task for central banks than halting deflation and depression.

Tom Petruno can be reached by e-mail at tom.petruno@latimes.com.