Fed Chairman Greenspan Taps Brakes on Inflation

WASHINGTON â€”  Ever since he became chairman of the Federal Reserve last August, Alan Greenspan has faced a persistent, nettlesome question: Can he measure up to his inflation-slaying predecessor, Paul A. Volcker?

Now he is trying to prove he can. Responding to new evidence of the economy’s surprising strength, the Fed this week appears to have reversed its move earlier this year toward slightly lower interest rates, analysts say. The key federal funds rate closely monitored by the central bank--the cost on overnight reserves banks lend each other--moved up Tuesday to 6.81% after trading at an average rate of 6.58% through February and March.

“The Fed is sending a loud and clear signal that it intends to put a very tight leash on the recovery,� Ira Kaminow, chief economist at the Government Research Corp., said here Tuesday. “The whole tone has shifted toward a heightened concern about inflation.�

The Fed’s initial move may not be enough. Greenspan and his colleagues still may find themselves facing a touchy election year choice later this year: whether to push up short-term interest rates further even if that would raise the specter of possible recession before November’s elections.

And those who expect the Fed, whose six Washington-based board members were all appointed by President Reagan, to opt for politically expedient low interest rates could be in for a surprise.

“Despite their reputation as wild-eyed Reaganite expansionists, I’m convinced this Fed is determined to keep inflation under control,� said Stephen Axilrod, vice chairman of Nikko Securities in New York and the former top monetary policy staff member at the Fed. “Indeed, the more people question the credibility of the new group, the more they are going to be determined to show the image is false.�

Inside the central bank’s cloistered offices, where the halls are almost always deserted and people rarely speak above hushed tones, Fed officials are in an unusually boisterous mood these days. They are exulting, understandably, over the Fed’s widely acknowledged role in preventing the stock market collapse of last Oct. 19 from damaging the financial system and throwing the economy into a recession.

“If the financial markets had gone into gridlock because of a lack of liquidity from the banking system, that would have been the real disaster,� said Fed board member H. Robert Heller. “That was forestalled, and I’m not reluctant to say we deserve a pat on the back for our contribution.�

Gary Stern, president of the Federal Reserve Bank of Minneapolis, said the economy has been remarkable for its resilience. “There continue to be risks on both sides,� he said in an interview shortly before the Fed’s policy-making committee met last week. “But right now it looks to me like the economy is starting to move in the direction where we have to show greater concern about inflation.�

Even before inflation re-emerged as the chief economic threat, Fed policy-makers had little time to rest on their laurels.

Shortly after the first of the year, Greenspan was forced to fend off criticism from two of the Administration’s “monetarist� economists, White House economic adviser Beryl Sprinkel and Treasury Undersecretary Michael Darby.

These economists, watching almost nothing except the weak growth of the money supply in 1987, mistakenly contended that the economy was on the verge of a downturn. Darby urged the Fed to loosen monetary policy.

But for a variety of reasons, Fed officials argue, the growth of the money supply has lost its usefulness as a guide to running monetary policy. And most members of the Federal Open Market Committee, the Fed’s key policy-making body, seem to be virtually ignoring changes in the money supply.

The attacks from Administration officials, ironically, have helped Greenspan soothe fears that the Reagan-appointed Fed remains too close to the White House. Greenspan chalked up points in Congress when he publicly criticized Darby, whose letter was written just before the Open Market Committee’s February meeting.

Low-Key Approach

“It gave the Fed a golden opportunity to display its independence,� said a Fed member who asked not to be identified. “If Mike Darby hadn’t existed, Alan Greenspan would have had to invent him.�

Greenspan may have more trouble dealing with the diverse views on his own board than deflecting such clumsy stabs at influencing monetary policy.

In contrast with Volcker, who tended to rule the central bank with a firm hand and remained aloof from other members, Greenspan has established a low-key approach that emphasizes collegiality.

“He has quite a different style from Volcker, who was more of a loner,� said Fed board member Wayne Angell. “Alan has a lot of skill in getting a group to work together, pulling out from this person or that person diverse views and then forging a consensus. It’s exactly the right approach for the Federal Reserve at this time.�

Jitters May Remain

But Greenspan, in trying to establish his own anti-inflation credentials, faces a kind of monetary Catch-22.

If the Fed is successful--or just lucky--virulent inflation will not return or even threaten. But without the threat, few people are likely to credit the Fed with keeping inflation bottled up.

Investors probably will continue to worry that Greenspan has not endured a trial by fire like Volcker’s, who was able to make his mark so indelibly because he took over when inflation was already raging out of control in 1979. That means that financial markets, jittery since the crash, are likely to remain so, providing the Fed little leeway in managing monetary policy.

By contrast, if the Fed allows inflation to get rolling again, it can always gain credit for beating it back into submission with the sledgehammer of high interest rates, even if the consequence would be a painful economic contraction.

“That’s one of the paradoxes,� Fed Vice Chairman Manuel Johnson acknowledged. “The better job we do, the less people will need to pay attention to us. But I’ll settle for that. I’d rather not get blamed for letting inflation out of the bag in the first place.�

The task facing the Fed is not unlike that of a homeowner trying to trim his hedge. It must keep constantly on the lookout for outbreaks of an impending price spiral, prudently trimming by raising interest rates judiciously to avoid having to hack away all at once at a suddenly misshapen economy.

The difficulty is that a growing economy, with its countless offshoots, provides a variety of indicators to future inflation. The Fed’s board is split over which clues are the most important.

Mixed Opinions on Fed

“One reason for the difficulty in conducting policy . . . is the lack of a single, reliable intermediate guide upon which to focus policy,� Johnson said in a recent speech in New York.

Since joining the board more than two years ago, Johnson and Angell, leaders of the “supply side� group on the board, have been pushing the Fed to pay more direct attention to such unconventional inflation indicators as rising commodity prices, declines in the dollar’s value and widening gaps between long-term and short-term interest rates.

While not excluding more traditional indicators, they believe these market-oriented signals can provide an early warning of price pressures.

Others in the policy-making council have doubts about the reliability of signals sent by the financial markets.

“I personally don’t see anything magical about yield curves or exchange rates,� said Stern, who is a member of the Open Market Committee. “In practice, the Federal Reserve tries to absorb as much information from as many sources as possible, but it is pretty inefficient to pick out a few particular targets to the exclusion of a lot of other things.�

Stern and others, including Greenspan, tend to place more emphasis on economic conditions such as employment levels and production constraints, which they are counting on to provide evidence if the economy shows signs of becoming overheated.

Some financial analysts worry that the cacophony of viewpoints inside the Fed will make it more difficult for the central bank to execute needed policy shifts. “If the data are sending different signals,� said Allen Sinai, chief economist at Boston Co., “it may be more difficult for a majority to agree on stronger measures.� Under most likely circumstances, though, neither Greenspan nor Johnson foresees any essential dispute.

Policy Has Succeeded

“I think the two approaches are complementary rather than contradictory,� Johnson said. “I can’t see where they would disagree on the fundamentals.�

Indeed, within both camps there is remarkable agreement on the goals of monetary policy--to contain inflation.

Fed officials almost universally express the conviction that higher inflation undermines the prospects for long-run growth rather than enhances it. That stands in sharp contrast to the still-popular belief that deliberately creating inflation aids the large majority of Americans at the expense of the rich and can help the economy generate stronger growth.

Outside analysts concur that the Fed has been quite deft so far in containing inflationary pressures and keeping the economy on an even keel.

“Monetary policy has succeeded since 1983 in braking the economy without breaking it,� contended Roger E. Brinner, a senior economist at Data Resources Inc. “By preventing booms, the Fed has also averted busts.�

But the closer the economy gets to full employment of its resources, the more difficult the Fed’s balancing act becomes.

“What if the economy . . . continues growing fast enough to produce price pressures?� asked Alan Stoga, chief economist for Kissinger Associates in New York. “You’ve got these dramatic differences that make policy much more difficult. Who’s in recession and who’s not? Texas still is. Illinois is not. I think New York will be. Do you respond to higher prices?�

And then what happens to the weakest links in the economy--such as failing Texas banks and many of the Southwest’s riskiest savings institutions--if the Fed is compelled to push up interest rates? Would they break?

“That,� Stoga said worriedly, “really is Alan Greenspan’s nightmare.�