Commentary: Has The Fed Painted Itself Into A Corner?

It's crunch time at the Federal Reserve. The two bogeymen that Fed Chairman Alan Greenspan & Co. fear most--higher inflation and a collapsing stock market --are threatening to come out of the closet and bring this nine-year-old economic expansion to a screeching halt.

When the Labor Dept. announced on Apr. 14 that consumer prices outside of food and energy rose in March at their fastest pace in more than five years, the stock market tanked. The apparition of higher inflation spooked investors. They were afraid that the 0.4% rise in core prices had boxed the Fed into bigger rate increases than the quarter-point hikes it has gingerly made five times over the last 10 months.

Thus, Greenspan faces one of the toughest dilemmas of his long tenure at the Fed. The right policy is far from clear--and the risks of doing damage by getting it wrong are growing. The inflation threat has heightened pressure to raise interest rates more sharply than the Fed has up till now. But doing that--as the recent market collapse showed--poses big dangers. Not only would stocks likely plunge again; a more aggressive Fed would risk sending the economy spinning down as well. All in all, it's quite a corner the Fed may have painted itself into.

UNCERTAINTY. So how does the evidence stack up? Well, plenty of uncertainty remains about how real the specter of higher inflation is and how fast the turbo-charged economy can grow. Yes, the shiver-inducing jump in March prices was broad-based, with prices for apparel, medical care, cars, and cigarettes all up. Yet a lot of the rise resulted from factors that probably won't be repeated. Cigarette prices rose largely because of a 55 cents-a-pack tax hike in New York State. Car prices rose because General Motors Corp. stopped offering buyers incentives to turn in their old GM models for new ones. "There's too little information to make a call that the March rise portends a higher trend," says Patrick Jackman, the Labor Dept. statistician in charge of compiling the price data. After all, we've seen this before. In April, 1999, consumer prices also jumped unexpectedly, sending shudders through the financial markets. But the scare proved short-lived.

None of that has stopped anti-inflation hawks at the Fed from arguing that the central bank needs to become more aggressive in tightening credit. Well before the latest news on consumer prices, the hawks were pushing to raise the ante and boost rates by a half percentage point at a time. Experts say that the squawks are sure to get louder at the Fed's next meeting on May 16.

Even Greenspan--perhaps the Fed's biggest believer in the ability of the New Economy to grow rapidly without generating inflation--is getting a little antsy. He told a private meeting of finance ministers and central bankers from major industrial nations on Apr. 15 that he couldn't rule out the possibility the economy was starting to overheat, although he didn't think that was happening. The Fed chief spoke "very frankly" about the risks, Italian Treasury Minister Giuliano Amato told reporters.

For Greenspan, the key to the inflation outlook is labor costs. If the jump in March consumer prices was just a bid by companies to widen profit margins, he isn't likely to find it all that worrisome. Under those circumstances, companies will only be able to raise prices so far before rivals start undercutting them. If, instead, prices are rising because companies across the board are trying to cover rising labor and other costs, that's a different story. In that case, the risk of an inflationary spiral is greater because companies everywhere face pressure to raise prices.

For now, Greenspan believes the slow and steady approach continues to do the job. The productivity miracle hasn't disappeared, and it's helping to hold down labor costs and to prevent overheating. And if that starts to change? Expect the Fed chairman to begin to think about finding himself a new paintbrush.

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