In some ways, the questions are unfair. The Fed’s economic powers, though immense, are crude. Perfection isn’t possible. In the 1950s, the Fed was said to “lean against the wind,” lowering interest rates during slumps and raising them during booms. Things haven’t changed much. The Fed mainly influences short-term interest rates, which in turn influence-often with dehys of a year or more-the rest of the economy. More important, there are no entirely predictable relationships between the Fed’s actions and the economy’s behavior. Sometimes the economy is more (or less) sensitive to shifts in interest rates.
Still, the Fed is now expected to sustain what Labor Secretary Robert Reich calls the “Goldflocks expansion”: it’s neither too hot nor too cold. Since early 1993, the economy has created 5 million jobs. Car and truck sales have boomed. In 1994, they’ll exceed 15 million units, the best since 1988. Meanwhile, inflation remains low; consumer prices increased by 3 percent in the past year. Enter Greenspan. By all accounts, the Fed will raise short-term interest rates this week, The guessing is that the Fed Funds rate (the rate at which banks lend to each other) will increase by half a percentage point to 5.25 percent. This would be the sixth increase since February, when the rate was 3 percent.
The theory is that higher rates are needed to restrain the economy so that lower unemployment (5.8 percent in October) and higher factory use don’t lead to inflationary bottlenecks. Some economists think the Fed can orchestrate noninflationary growth. For example, the forecasting firm of DRI/McGraw-Hill predicts that the economy will slow in 1995 and then expand steadily through at least 1997. Between now and then, annual economic growth would average 2.5 percent, unemployment 6 percent and inflation 3.3 percent. But there are plenty of doubters. Unfortunately, half think the Fed is raising rates too fast, while the other half think it’s not raising them fast enough.
Start with inflation hawks. Economist John Makin of the American Enterprise Institute says that the Fed’s strategy “virtually guarantees” that inflation will reach 5 percent. Financial markets also worry that the economy is slowly overhearing. In the past year, such fears have helped push up long-term interest rates on bonds and mortgages by more than 2 percentage points. Scratch beneath the surface, and the placid inflation statistics don’t look so reassuring.
Until 1994, “we’d have some price increases, but you could handle them through greater productivity,” says Robert Koch Jr., purchasing manager for Briggs & Stratton Corp., a $1.3 billion maker of engines for lawn mowers. “Now, they’re across the board.” In the past year, the price for aluminum (used for engine blocks) has gone from 53 to 88 cents a pound, the price for plastic resins (used for gasoline tanks) is up 10 percent and the price for copper (used for electric parts) has risen from 72 cents a pound to $1.22, Similar increases bedevil many firms. Beverage companies are paying more for cans and plastic bottles; car companies are paying more for steel.
Wait a minute, say the doves. There’s no need to threaten further job gains. Sure, raw material prices have jumped. But they represent only a small fraction of total production costs. Moreover, these prices are rebounding from low levels and their upward spurt could be temporary. In October, the government’s wholesale price index actually dropped. Finally, goes the counter-argument, fierce competition prevents many cost increases from being passed through to final prices. Tracy O’Rourke, head of Varian Associates, a $1.5 billion electronics manufacturer, contends his company hasn’t raised average prices for five years. “Very few industries can raise prices and still compete in today’s competitive global marketplace,” he says,
In short, the Fed is being assaulted from both directions. In a recent letter, the National Association of Manufacturers opposed higher interest rates, which might “choke off demand and produce a sharp slowdown,” as NAM president Jerry Jasinowski wrote Greenspan. By contrast, Wall Street investors and traders believe that raw-material price increases are simply the harbingers of higher retail and wage inflation. Compounding the confusion are two other economic unknowns:
The economy’s long-term growth potential: It’s assumed to be about 2.5 percent a year, reflecting a 1 percent increase in the labor force and a 1.5 percent increase in productivity (output per hour worked). Recovering from recession, the economy can grow faster. In the past year, growth has been 4.3 percent. But once the economy reaches its peak capacity, efforts to make it expand faster than its potential merely generate inflationary shortages. But suppose potential growth is higher (say, 3 percent) or lower (say, 2 percent). No one really knows, because estimates of the productivity trend are only educated guesses.
The NAIRU: This is economists’ jargon for “nonaccelerating inflation rate of unemployment,” often called the “natural” unemployment rate. It means “full employment” in the sense that, if joblessness goes lower, inflationary wage pressures emerge. The NAIRU is generally estimated at about 6 percent. If so, the economy is already in inflationary territory. But again, estimates vary. Some go as high as 6.5 percent, others as low as 5.5 percent. More part-time and temporary workers reduce the NAIRU, claims Jasinowski. Though employed, many would like full-time, permanent jobs, and their presence stifles wage pressures. With a lower NAIRU, faster growth is possible.
Even inside the Fed, opinions differ, and Greenspan’s voice-though dominant–is only one among 12 on the “open market committee” that sets policy. What should it do? Essentially, it should err on the side of fighting inflation. The economy has much inertia; small changes in interest rates don’t quickly stop its momentum. Despite higher rates in 1994, growth has exceeded expectations. Housing has been resilient. In September, home sales were about the same as in February. Some buyers have offset higher rates by shifting from fixed-rate to adjustable-rate mortgages that usually have lower rates. In February, 22 percent of buyers chose ARMs; now, that’s 42 percent, says economist David Lereah of the Mortgage Bankers Association. Moreover, growth in 1995 should also be helped by higher exports generated by recoveries in Europe and Japan.
Of course, the Fed might goof. But if interest rates go too high, they can be relaxed later with only modest damage to growth. By contrast, inflationary mistakes are harder to cure. For three decades, the Fed has striven to prolong expansions with easy money policies. Every time, the effort has backfired and led to higher inflation and economic excesses. The failure of the 1980s involved consumer overborrowing and the overbuilding of offices. Recessions occurred anyway and were probably worse than necessary. Why repeat the error? Inflation is not yet a wind. But it is a breeze. Greenspan’s Fed shotrid lean–harder.
