September 19, 1996

The Fed Should Keep Its Head

By ROBERT EISNER

VANSTON, Ill. -- How low would inflation have to be to calm the economic doomsayers? Right now, it is virtually zero. Consumer prices rose by a mere one-tenth of 1 percent last month, and producer prices are practically unchanged. Nevertheless, inflation hawks at the Federal Reserve are pressing for a rise in the most basic short-term interest rate when a Fed policy-making group meets on Tuesday.
The hawks' premise is that the economy is doing too well. So although there is virtually no current inflation, they say we must slow the economy to prevent future inflation. They want the Fed to tighten the money supply by raising the 5.25 percent Federal funds rate, which banks charge one another, by as much as one-half of a percentage point.
But increasing the Federal funds rate even slightly will have a ripple effect on other rates, because of the tighter money supply and the expectation that the Fed, once it starts raising rates, will continue to do so.
These higher interest rates will reduce consumer spending, as borrowing costs increase. They will curtail home buying and construction, as mortgage rates rise. They will cut state and local spending, as the costs of bond financing goes up. They will hold down business investment. And to the extent that the markets have not already anticipated higher rates, they will drive down stock prices. All this will contribute to lower sales and production, meaning that more people will be without jobs.
Why would any well-intentioned person want to reduce investment in the future and put people out of work? To the inflation hawks, unemployment is already too low. Their conclusion stems from one of the more dismal dogmas of our dismal science -- the belief that there is a "natural rate of unemployment" below which the economy cannot go without bringing accelerating inflation. That "natural" rate, until recently taken to be around 6 percent, is called the Nairu, the nonaccelerating inflation rate of unemployment. Since unemployment has been below 6 percent for two years -- it is now 5.1 percent -- we are presumed to be in dire danger. Many of the alarmists say the economy can grow little more than 2 percent annually without reducing unemployment further. Since output grew at 4.8 percent annually in this year's second quarter, the economy must now be restrained, they say.
We can hope that a majority of the Fed group meeting on Tuesday sees the folly of these arguments. Wages have begun to catch up with past inflation. But labor costs, counting total compensation and productivity, are not rising. And with good profits and considerable competition, companies are unlikly to pass the cost increases that do occur.
What's more, after two years of unemployment below the "natural" rate, other economists are questioning whether the Nairu is applicable. Some of us doubt that the concept makes any sense at all. Others say that while high unemployment may reduce inflation, low unemployment may not increase it. Prof. Robert Gordon, a Northwestern University economist who has long set the "natural" rate of unemployment at 6 percent, now states that it is more like 5.1 percent, the current jobless rate. Accelerating inflation, he argues, is not a serious threat now and is unlikely to be in the near future.
The Fed would do well to remember that along with its responsibility to curb inflation, it has a mandate -- however ignored -- to reduce unemployment. Its legal obligation is to aim for a 4 percent jobless rate. And each percentage point of reduced unemployment puts more than 1.3 million people to work.
If I were running the Fed, I would urge lowering interest rates to stimulate growth and reduce unemployment even more. The best we can hope for on Tuesday, however, is that the Fed's policy-making group will come to order and quickly adjourn -- without raising rates.
Robert Eisner, an economics professor at Northwestern University, is the author of "The Misunderstood Economy."

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