Risk of Too Much Success Weighs on Fed Rate Policy

Fed Chairman Alan Greenspan’s reputation as a sure hand in piloting monetary policy owes a lot to the events of 1994. By engineering a series of interest rate increases, Greenspan helped subdue a flare-up of inflation and set the stage for the economic boom that the nation has enjoyed since.

Today, after another year of Fed rate hikes to combat new inflation worries, evidence is emerging that Greenspan and the Fed are making headway again in containing price increases. But, this time, are they on the verge of succeeding too well and denying ordinary Americans the continued rewards of economic growth?

That’s one of the big risks facing Fed policymakers when they decide today whether to push interest rates up further.

The Fed’s immediate aim is to guide the economy into a so-called soft landing that will slow business enough to shoo away inflation without going so far as to induce a recession. To that end, the Fed has pushed up rates six times over the last year, lifting the benchmark federal funds rate--the overnight loan rate among banks--to 6.5% from 4.75%.

Already, signs of a cooling economy are mounting. According to federal figures, the private sector lost 116,000 jobs in May, the worst turnabout of its kind in 8 1/2 years. Other recent reports have shown declining consumer spending and home construction, and the Conference Board research group said Tuesday that consumer confidence fell this month from May’s record high.

Monday’s surprising report that sales of existing homes rebounded by 4.3% nationally in May underscored the uncertain picture facing the Fed while doing little to reverse the growing sense that business is slowing.

Stand Pat, or Another Rate Hike?

What’s especially troubling for some Fed watchers, ranging from union-friendly analysts to some Wall Streeters, is the central bank’s apparent conviction that low unemployment and rising wages are sure signs that inflation lies ahead. By these observers’ reckoning, productivity gains have significantly outpaced pay increases over the last decade and there is room for further pay increases without triggering inflation.

“The Fed is on the right track now,” said Mickey D. Levy, chief economist at Bank of America in New York. But, he added, if the Fed continues to push up interest rates, then “monetary policy could inadvertently become too tight and turn a benevolent soft landing into something harder.”

Christian E. Weller, an economist at the Economic Policy Institute, a liberal think tank in Washington, said that if the Fed is acting to squelch wage increases it “is certainly cheating workers out of their fair share.”

“I’m always worried that the Fed will take away the punch bowl when the economy gets good for workers,” he said.

Weller thinks that a bigger threat to the economy than rising wages is the high level of consumer debt. If the Fed raises borrowing rates further, he said, consumers could find themselves harder-pressed to pay off their debts.

The results, Weller said, would be more bankruptcies, reduced consumer spending--and, perhaps, the unraveling of the nation’s economic expansion.

But banking and Wall Street economists such as Robert V. DiClemente, chief U.S. economist for the Salomon Smith Barney investment firm, applaud the Fed for moving to preempt inflation. He likened the current situation to the economic conditions in 1994, when inflation last threatened to heat up.

“The truth is that, by keeping inflation to a minimum, it’s probably creating the best environment for maximum growth and rising living standards,” DiClemente said. He called it ironic that the Fed is “being attacked for creating the best environment that we could have.”

Analysts generally predict that the Federal Open Market Committee, which boosted rates half of a percentage point when it met in May, will stand pat today and give past increases a chance to take hold. Still, many Fed watchers expect the central bank to engineer another quarter-point rate hike, or two, later this year before calling it quits.

The Fed’s policymakers want neither to move too cautiously and be blamed for the next bout of inflation nor to move too aggressively and be blamed for the next recession.

In addition, the Fed traditionally has been reluctant to step into the middle of a presidential election contest by raising or lowering rates in the heat of the campaign. Such actions can become emotional campaign issues in themselves because of their import for jobs, wages and prosperity.

Under Greenspan, however, the Fed several times has defied conventional wisdom.

For instance, in August 1988, just three months before then-Vice President George Bush defeated Democratic presidential candidate Michael Dukakis, the Greenspan-led Fed boosted the federal funds rate to 6.5% from 6%.

Likewise, in 1994 and early 1995, Greenspan faced pressure not to disrupt the then-surging U.S. economy. In addition, Mexico in late 1994 had just plunged into an economic crisis that rippled through Latin America, threatening a key U.S. export market.

Even so, the Fed continued to boost short-term rates aggressively, lifting the federal funds rate from 3% in early 1994 to 6% by early 1995, before Greenspan and his allies believed the threat of inflation was extinguished.

The nation is enjoying the payoff from a record-long economic expansion that began in 1991 and, with the help of Fed policy, steered past threatening circumstances in the mid- and late 1990s. Along the way, the expansion helped lift corporate profits and cut unemployment to a 30-year low, before the jobless rate edged back up to a still-low 4.1% in May.

For the first time in two decades, the boom also began in the mid-1990s to finally produce wage increases that outpaced inflation.

Containing inflation without interrupting economic growth is especially crucial to such areas as Los Angeles, which was late to join the expansion and whose labor market never has gotten as hot as that of the rest of the nation. In addition, it is important to cyclical industries such as home construction and retailing that ride on the fortunes of the overall economy.

At the same time, inflation traditionally has been a red flag to economic policymakers because it consistently has been followed by recession. Generally speaking, the uncertainty created by inflation makes employers and financial institutions less willing to make long-term investments that build the economy.

‘Running Blind’ Without a Compass

Among other things, rising prices prompt banks to raise lending rates to cover their own higher borrowing costs and to offset the damage that inflation does to the value of their financial assets.

Higher interest rates on loans, in turn, typically mean that businesses borrow less and grow more slowly.

But these days, the job of slowing the economy just enough to get the inflation-fighting job done is complicated by a host of factors. For one thing, no one knows how much the emergence of the “new economy,” including the Internet and other new technologies, has changed the way inflation works.

“The Fed is almost running blind. They don’t have a compass anymore,” said Sung Won Sohn, the Minneapolis-based chief economist of Wells Fargo & Co. As a result, Sohn said, he expects the Fed to cautiously brake the economy with additional interest rate hikes later this year.

“When you’re not sure of yourself, you don’t run fast; you run slowly, so you don’t run into a rock,” he said.

Some economists even are challenging the standard wisdom that lower unemployment rates and faster economic growth translate into higher inflation. They urge the Fed to focus on maintaining stable growth in the money supply rather than react to factors such as declining jobless rates and wage increases. Some of these critics contend the Fed has let money supply grow too rapidly in recent years.

What’s more, the effect of interest rate increases often doesn’t become apparent in the economy for six to 18 months. Thus, much of the rate-boosting already imposed by the Fed over the last 12 months hasn’t been felt yet.

That leads some analysts to believe that further rate hikes could prove to be overkill that, at worst, tips the nation into recession.