Would a Pinch of Inflation Help?

In his 14 years as head of the Federal Reserve, Alan Greenspan has earned a well-deserved reputation as an ardent advocate of price stability. But the Fed chairman has not been afraid to put his reputation as an inflation-fighter on the line when he thought the economy would be better off for it. In the mid-'90s, as unemployment fell and the Fed's inflation-phobes screamed for tighter credit, Greenspan held off from raising interest rates sharply, convinced that productivity would keep price pressures in check. He was right, and the economy soared.

Now, the Fed chief looks ready to again test his credibility as an inflation foe as he strives to rekindle the New Economy. In presenting the Fed's semiannual economic update to Congress on Feb. 27, Greenspan signaled that he will tolerate a pickup in inflation if that's what it takes to ease companies' pinched profit margins. That has big implications for monetary policy: Greenspan will be slow to tighten credit as the recovery gains steam to give profit-starved companies a chance to jack up prices.

It's a risky strategy, to be sure. If bond investors conclude Greenspan has gone soft on inflation, they're likely to push long-term interest rates sharply higher, aborting the recovery in the process. "Greenspan has a lot of credibility, but he'd have a big sales job to convince the market of his stance," says Louis Crandall of consultants R.H. Wrightson & Associates.

The Fed chief thinks it's a risk worth taking. Sure, the economy is bouncing back smartly from its recession last year. But much of the momentum is coming from a short-lived rebuilding of inventories after savage cutbacks last year. The recovery could sputter later in the year if capital spending doesn't pick up. Increased investment is also critical to keeping productivity elevated. "Business investment will have to turn around if we are to sustain the recovery," Philadelphia Fed President Anthony M. Santomero says.

For recession-chastened businesses to step up spending, though, profits will have to get a lot stronger. Indeed, while the recession may have been mild, the hit to profits during the downturn has been severe, in part because businesses overbuilt so much in the boom. According to the Fed, nonfinancial corporations' profits as a share of their output fell to 7 1/2% last year, the lowest level in nearly 20 years.

Greenspan believes any rise in inflation early in the recovery will prove short-lived. Industrial companies are operating at 74% of capacity, the lowest level in 18 years. With so much slack in the economy, companies can raise prices only so far in response to firming demand before competitors undercut them.

Controlling inflation longer-term will depend on holding the line on corporate costs, particularly unit labor costs, the biggest component of company outlays. If those costs take off, inflation may spiral upward as companies try to raise prices to recoup their expenditures. But with productivity strong and unemployment higher than it has been for a while, Greenspan sees little, if any, threat of that happening. If anything, he seems more worried about deflation. With inflation running just 1 1/2% last year and business awash in excess capacity, that's no surprise.

When growth took off in the 1990s, Greenspan bet on inflation remaining in check. That winning wager helped launch the New Economy. Now, once again, he's counting on the New Economy to keep costs contained and inflation low. And he's willing to hold interest rates down--and put his credibility on the line--to prove it.

By Rich Miller in Washington

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