How Long Can The Fed Steer Without A Map?

It was a startling admission for a Federal Reserve chairman. In congressional testimony on July 20, Alan Greenspan admitted that the central bank no longer has any reliable guide to future economic growth and prices. In effect, the Fed is now flying blind as it wrestles with whether to nudge up interest rates to prevent an acceleration of inflation.

Is that cause for alarm? Greenspan has a reputation as a good seat-of-the-pants pilot, but he's not perfect. In 1990, he promised to bring an economy running out of fuel to a "soft landing." Instead, we got the 1990-91 recession.

Greenspan deserves credit for abandoning money-supply growth targets: M2 is no longer a good forecast tool, since it doesn't count the money pouring into stocks, bonds, and mutual funds.

The problem is, the Fed hasn't found a replacement. True, the central bank has always relied on instinct. But policymakers want a benchmark to gauge their course, and the financial markets need a standard for judging monetary policy.

HOT DEBATE. No wonder opinions are so divided about the course of interest rates. For every forecaster who wants the Fed to ease in the face of soggy growth and stable prices, there is an economist convinced that inflation lurks and the Fed should tighten. "The Fed needs to produce a targeting mechanism that answers the question `How you gonna fight inflation?' or it risks a decline in market confidence," warns Lawrence A. Kudlow, chief economist at Bear, Stearns & Co.

So, Greenspan's staff is searching for an objective measure that will predict price pressures. "We need something well in advance so the actions we take to suppress incipient inflation can be very modest," he told a House Banking subcommittee. "We don't want the surging inflationary instabilities that occurred in the past, which required draconian action."

Greenspan's prose masks a raging debate within the Fed about the inflation outlook. Hawks, such as Governor Wayne D. Angell, believe the Fed should start tightening immediately. Others, including Philadelphia Fed President Edward G. Boehne, say weak growth and recent price moderation argue against higher rates. The Clinton Administration and many private economists, noting the sorry state of industrial economies around the world, think the Fed should provide a shot of monetary stimulus. Greenspan clearly is prepared to tighten, but he's not sure when.

GUESSWORK. That's why he really needs a new crystal ball. Greenspan suggests that the new guidepost might be "real" interest rates--that is, nominal rates adjusted for inflation. But he admits that it would be a tricky calculation, because it would require guesswork about inflationary expectations of long-term lenders. Angell wants to use the prices of gold and a basket of other commodities as an advance warning system. But Greenspan, who thinks commodity prices aren't a broad enough measure, opposes the idea.

Lacking any clear evidence of worsening inflation, Greenspan seems to be following the right flight path. But because he can't see beyond the horizon, he'll have to respond very quickly if it turns out that price pressures are growing. Otherwise, hypersensitive financial markets might grab the controls away from the Fed, sending long rates soaring, and force the economy into a spiral.

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