Wanted: A Fed That Doesn't Jump When Inflation Says `Boo'

President Clinton will soon fill two vacancies, and possibly three, on the seven-member Federal Reserve Board. He can try to reassure Wall Street by appointing "sound" figures who embrace the orthodoxy of tight money, or he can appoint distinguished, technically competent experts committed to low interest rates and steady economic expansion. The recent behavior of Fed Chairman Alan Greenspan suggests that Clinton should seize the moment and name advocates of low rates and stable growth.

Greenspan performed well last year, rewarding deficit reduction with low and stable rates, but he blundered in early February. Partly out of concern that the economy might be overheating and partly to reassure money markets of his own anti-inflationary zeal, Greenspan first declared that rates had to rise; the Fed soon hiked short-term rates a quarter point. Greenspan had predicted that raising short-term rates would calm markets and hence bring long-term rates down. But precisely the opposite happened. Money markets, observing the Fed's concern, immediately presumed inflation must be a real threat--and bid up long-term rates.

The Fed and the markets ignored underlying economic facts. On the very day the bond market tanked, the consumer price index showed a zero price increase for January. Financial analysts seeking evidence of inflation dismissed the CPI and focused on an obscure index of intermediate goods published by the Philadelphia Federal Reserve Bank--one based on a survey of expectations, not actual prices.

In a similar miscalculation, well-placed sources say, Chairman Greenspan seized on the Bureau of Labor Statistics' January payroll survey as evidence of inflation. Greenspan received this survey on the eve of the Feb. 4 rate hike. The raw data, based on a survey the week of Jan. 9 from 200,000 reporting businesses, seemed to show wages increasing at a surprising annual rate of 7%. All other reports showed wages lagging behind inflation.

ARTIFICIAL HIKES. When BLS economists took a closer look at the improbable data, they noticed that the survey also reported about 100,000 fewer jobs than anticipated, and a sharp rise in the average workweek. Evidently, during that snowy week, many employers told part-time workers to stay home. Full-time workers then put in longer hours, and since they have higher earnings, that artificially pushed up the reported "average" pay. The apparent wage inflation was a statistical glitch.

Meanwhile, Greenspan's ill-timed rate hike has become a self-fulfilling prophesy. The Fed chairman compounded the damage on Feb. 23 when he told the House Banking Committee that rates might be raised again, though he wouldn't say when. Such talk only encourages money markets to believe the Fed is still fearful of inflation and to repeat a now-familiar pattern: Because the markets don't know when the other shoe will drop, or how heavily, they demand higher yields for investing long.

Despite a robust fourth quarter, wage inflation remains nonexistent and capacity is still mostly slack. Commodity prices such as steel, lumber, and zinc have inched up, but their effect on raw-materials prices has been more than offset by the steep drop in oil prices. Most economists expect the first-quarter growth figure will be 3% to 3.5%--far below the 7.5% posted in 1993's fourth quarter.

The real blunder is not the rate hike but the Fed's way of implementing it. If the Fed thinks it's dangerous for short-term rates to lag behind the inflation rate--a legitimate concern--it would be far better to announce a one-time rate hike and then to keep rates steady. Instead, Greenspan is given to Delphic utterances and endless gradualism, which only spooks markets and produces higher-than-necessary long rates.

SMART CHOICES. The Fed needs a different philosophy of monetary management, one that doesn't panic markets and sabotage growth by imagining phantom inflation. Clinton can contribute by choosing his appointees wisely. White House economist and former BUSINESS WEEK columnist Alan Blinder, said to be Clinton's choice for Fed vice-chairman, would be perfect. He is moderately Keynesian and widely respected.

Two other smart choices would be Brookings economist George L. Perry, also on the short list, and Assistant Treasury Secretary Alicia H. Munnell, who logged experience in the Federal Reserve system as chief economist for the Boston Fed Bank. Munnell, however, is said to be a reluctant candidate. If White House talent scouts seek another woman candidate, they should avoid the Administration's unfortunate habit of sometimes letting gender trump philosophical compatibility. It would be a shame if the worthy goal of affirmative action led to another tight-money hawk who happened to be female.

A Fed majority committed to stable and low rates would be tonic for the economy. Markets might react nervously to such appointees at first, but once the board's course was clear, markets would take their cue from actual policy. Nothing less than stable growth is at stake. Clinton must not flinch.