Fed Will Have to Lead in Dampening Demand and Slowing Inflation

Six years of strong expansion have brought the economy so close to capacity that a resurgence of inflation is now a clear danger. The Federal Reserve will play a critical role during the coming year in checking this rise of inflation. Since reducing inflation will require slowing the growth of the economy, the Fed’s policy stance will inevitably encounter opposition. The Administration’s attitude toward the Fed’s policy will therefore provide an early test of its seriousness about controlling inflation in the years ahead.

The inflation rate fell sharply from 1980 until 1986 but has been rising since then. Consumer prices increased less than 2% in 1986 but more than 4% in the past 12 months. Wholesale prices of manufactured products other than food and energy rose less than 1% in 1986 but more than 5% in the past 12 months. And the rate of increase of labor costs has jumped from 2% in 1986 to 3% last year and to nearly 5% now.

The increasing rate of inflation is not surprising in an economy in which the unemployment rate is lower than it has been for a decade and in which the utilization of industrial capacity has reached a level not seen since the high inflation days of the late 1970s.

If the economy doesn’t slow down in the months ahead, firms and employees will begin to compete with each other in trying to stay ahead of inflation. Once such an inflationary spiral of leapfrogging prices and wages begins, it becomes more and more likely that inflation can be reversed only by a very deep recession like the one that we had at the start of the 1980s.

But, with the right economic policies and a little luck, the current expansion can continue for years to come without a new recession. The key to continued expansion is a slower growth of demand that will reduce the inflationary pressures on capacity.

The best way to dampen demand is to reduce private and public consumption through the fiscal approach of changing the federal budget. This could be reinforced by revenue-neutral tax changes aimed at increasing the private saving rate. The alternative of a tight monetary policy to reduce business investment in plant and equipment and the construction of new homes would hurt long-term growth of output and our standard of living.

Unfortunately, the Federal Reserve may not be able to wait for budget and tax changes to slow the rise in demand. Although President-elect George Bush has promised to start budget negotiations immediately after Jan. 20, the earliest that new budget legislation will be enacted will be the end of the summer. And even after the budget changes are made, there are long lags (measured in months and even years) before government spending and revenue changes are effective in slowing demand.

Since fiscal policy will have a little role to play in slowing the economy over the next year, the Federal Reserve will have to bear the responsibility of preventing the economy from overheating. Unless the economy slows spontaneously because of a worsening of the trade balance or a change in households’ desire to save, the Fed will have to tighten credit and raise interest rates. The needed degree of tightening could be increased if an OPEC oil-price increase added to the inflationary pressures.

The Fed has made its intentions clear. The announced goals for monetary policy in 1989 are right on target for slowing demand. The Fed wants to see the rise in total demand slow from the 8% rate that we have seen in the past six months to less than 7%. This means that the underlying rate of real GNP growth would fall from more than 3% this year to less than 2.5% next year. If the Fed is successful in achieving this moderate slowdown, inflation should begin to subside.

There will undoubtedly be those in the Administration and Congress who are tempted to resist a tighter monetary policy. Tighter money and higher interest rates hurt key political constituencies, including home builders and mortgage borrowers, small businesses, sick thrift institutions and banks with large debts to less-developed countries. Moreover, slower growth would in itself mean a larger budget deficit in the short run. That could mean deeper spending cuts to avoid the automatic sequestration under Gramm-Rudman legislation.

The Bush Administration and Congress will ultimately have to resolve their differences in developing a long-run fiscal strategy. Once that occurs, it will be possible for interest rates to decline.

But for 1989 the key test of the Bush economic team will be whether it gives the Fed the necessary support in following a correct monetary strategy.