Inflation Or Illusion?

This was supposed to be an easy year for Alan Greenspan. The chairman of the Federal Reserve Board figured there would be little need for major changes in monetary policy, what with the economy slowly improving, President Clinton pushing deficit reduction, banks getting healthier, inflation in check...but wait a minute. Out of nowhere, inflation has popped into the Fed's scopes. Suddenly, Greenspan's reverie has ended.

Just a few weeks ago, it seemed inconceivable that the Fed would consider nudging up interest rates in the face of sluggish growth. But unexpected bad news on the price front in April has made the unthinkable thinkable. Now, after four years of declining interest rates, both central bank insiders and Fed watchers agree that the debate among monetary policymakers has shifted from "whether" to tighten money to "when."It's not a move that the Fed would make lightly. Higher rates would bring an abrupt end to Greenspan's honeymoon with Clinton, whose ardent courtship of the Fed chief included a seat next to Hillary Rodham Clinton at the President's Feb. 17 State of the Union address. The last thing Clinton wants is to have the Fed apply brakes to an economy that isn't even meeting the Administration's own measly 3% growth forecast. Tightening now also could jeopardize passage of Clinton's economic package. "If the Fed raises interest rates, the next sound you hear will be the breaking of the new china," warns a top Administration official. "To say the White House would go ballistic might be an understatement."

The markets feel the tension, too. The Dow Jones index jumped 55.6 points on May 19, as traders bet the Fed would not tighten. Ultimately, the markets may need reassurance that the central bank and its chairman still walk the anti-inflationary beat. "The Fed can't even begin to be seen as asleep at the switch," says David M. Jones, a veteran Fed watcher at Aubrey G. Lanston & Co., a New York government-securities dealer. Already, the price of gold, an early warning of inflation fears, has jumped above $380 an ounce, the highest level since early 1991. And the yield on 30-year Treasury bonds, which hit an all-time low of 6.75% this spring, briefly leapt above 7%.

"SLICE AND DICE." Meanwhile, there's growing pressure by some Fed members for a change. When the Fed's policymaking Federal Open Market Committee met on May 18, it knew that its prediction for a 1993 inflation rate lower than 1992's 2.9% was simply wrong. In the first four months of 1993, the consumer price index rose at a 4.3% annual rate, and producer prices at a 4.8% clip. "You can slice and dice it any way you want, but the fact is we have a new trend line showing higher inflation," says Lawrence A. Kudlow, Bear, Stearns & Co.'s chief economist.

The inflation numbers have since strengthened the hand of Fed hard-liners. Even at the FOMC's March meeting, anti-inflation hawks had dissented from the majority's decision to keep monetary policy on hold. "I'm not sanguine in regard to the outlook for inflation," said Fed Governor Wayne D. Angell, a leading hawk, before the May 18 meeting. Angell's concerns were echoed by Vice-Chairman David W. Mullins Jr.

Angell has been lobbying Fed colleagues to send the markets an anti-inflation signal by nudging up the federal funds rate, which banks charge each other on overnight loans. Since last year, the Fed has held the rate close to 3%--just about the inflation rate. But as price increases accelerate, Angell argues, federal funds should tighten--and insiders say he has been gaining support. If he and other hawks prevail, tightening could begin almost immediately.

It's not yet clear, though, whether the April inflation spurt is a false alarm set off by a rough winter and a big jump in produce prices--or a lasting trend. Without a definite answer, it's dangerous for the Fed to tighten too much, too swiftly. Before the April price figures came out, Greenspan said he did not see any signs of mounting inflationary pressures. And the Administration has been caught off guard by the prospect of tightening. Before the April numbers, "I hadn't heard one word here about monetary policy," admits a Treasury Dept. official.

Insiders say that for now, the Fed is likely to compromise by issuing an agreement known as an "asymmetrical directive." These instructions to Fed managers would give Greenspan time to determine if the inflation numbers are real--and the authority to nudge up rates without waiting for the next scheduled FOMC meeting on July 6. "We're seeing a turning point in Fed policy from a neutral stance to a bias toward restraint," notes a worried Administration official. "It marks a significant change."

CLOSED WALLETS. For Clinton, the change is definitely for the worse. Many economists argue that there is no basis for inflation jitters. Economies worldwide are weak, labor costs are rising slowly, unemployment is high, and consumers remain wary. "Companies are not able to make price increases stick, and there's a worldwide paucity of demand," says Robert E. Rubin, director of the National Economic Council. "It's hard to see any signs of inflation."

But the warnings are out there. Steelmakers have raised prices 10% to 20% this year, thanks to import barriers and tight supplies. And the dollar's fall vs. the yen has forced Japanese auto makers to raise prices. The Big Three have followed suit, albeit more slowly. There's always the possibility, too, that the economy is stronger than official statistics have suggested. A bit of evidence: the Fed's recent upward revision of factory-capacity utilization by 1.5 points, to 81.4%.

Doves argue that an increase in rates now could further shake business' faltering faith that the recovery is sustainable. Corporations, already nervous about higher taxes and the Administration's health-care reform plans, might pull back on investment. Furthermore, higher U.S. rates could frustrate moves by Germany and Japan to stimulate their economies--at Washington's urging. "For the Fed to tighten now, when you have global slow growth, would be an inconceivable error of policy," contends Allen Sinai, chief economist for the Boston Co. Economic Advisors.

With more than three years remaining in his term, Greenspan doesn't want war with Clinton. But the Fed chief also has made it clear that he's not about to throw away five years of hard work nudging inflation down. Should another month or two of data show price increases continuing at a 4% pace, he'll probably tighten the screws--and he has the clout to bring the board around to his way of thinking. That could mean it will be long time before Greenspan gets to sit next to Hillary again.

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