Federal Reserve Board Chairman William McChesney Martin was fond of saying that it is the Fed's job to take the punch bowl away just as the party really gets going. He argued that there was an inevitable trade-off between economic growth and inflation. So, he said, the Fed must raise interest rates when the economy shows signs of heating up in order to cool it down--abruptly, if necessary--to stop inflation.
But sometimes, when the economic moon and stars are in alignment, taking the punch bowl away at the right moment actually prolongs the party. Raising short-term interest rates can calm bond markets (and even lower long-term rates), boost equity markets, and extend an economic recovery. This is one of those times.
"Snugging" up short rates by 25 to 50 basis points, as Fed Chairman Alan Greenspan suggested he was prepared to do at recent congressional hearings, is probably the best thing that can happen to the economy right now. It will keep the bond market vigilantes at bay. By showing Fed determination, the minihike will act to extend the recovery through 1995 into 1996 and perhaps beyond. Killing off inflationary expectations today will pave the way toward fuller employment tomorrow. For there is more to fear from inflationary expectations than from real inflation.
This is one of those rare moments in economic history where high growth rates can gracefully coexist with low inflation. This has happened in the U.S. before: in the late 19th century, when big productivity gains and rapid expansion of world markets led to a happy combination of strong economic growth and price stability.
The same could be true today. The triumph of capitalism has dramatically expanded the world market economy and altered the growth-inflation equation. Price disinflation is under way as new supplies of capital, goods, and labor increase competitive pressures on U.S. companies, making them obsessive about cost-cutting. A capital-spending boom is boosting productivity. And technological innovation is driving down the cost of all digital products.
At the same time, growth is particularly strong, driven by the same forces putting downward pressures on prices. Satisfying the demands of a new global middle class is generating all-time-high exports for U.S. corporations. Building a new, entertainment-driven Information Superhighway is kicking the entire U.S. high-tech industry into high gear.
This unusual alignment of global and technological conditions means that the current economic growth potential of the country is higher than previously estimated. The U.S. is able to grow significantly faster than 2.5% without generating inflation. This will be true unless, sometime in the future, Japan, Europe, and Eastern Europe join the U.S., China, and Latin America in a synchronous expansion. Until then, if worries about inflation can be conquered by Fed snugging, America can proceed safely down the road of strong economic growth.