Inflation phantom haunts the Fed

NOW IT IS America's turn to engage in the Great Inflation Debate that has plagued Europe in recent years.

Was Alan Greenspan right to stalk the inflation menace by engineering aggressive increases in interest rates that stunned the markets and led to huge losses on Wall Street? Or did the governors of the Federal Reserve Board over-react, sacrificing hundreds of thousands of potential jobs when the core inflation rate shows no sign of growing?

In retrospect, after being caught badly off guard by the unexpectedly steep market slide, the Fed now says it was doing Wall Street a favour. Mr Greenspan and his fellow governors have let it be known that they wanted to generate a 'significant' sell-off in equities - to curb the speculative fever that was threatening a Japanese-style stock market crash. Of course, no one expected that consecutive short- term rate increases - three in three months - would completely unhinge the bond markets, creating not a 'sell-off' but a tidal wave of negative activity in equities markets.

The very banks that Mr Greenspan & Co are accused of trying to protect, at the expense of jobs and economic expansion, are floundering in a sea of trading losses.

The second-quarter results at Bankers Trust, Citicorp, JP Morgan, Chemical Bank and other big bank and non-bank investors are expected to reflect these losses. One Fed official said the US central bank was so preoccupied with curbing speculation in equities that it failed to realise that the real 'bubble' was in bonds.

Critics contend that the Fed over-reacted and is poised to do so again, to prevent an elusive outbreak of inflation that does not appear to be grounded in economic results. True, the US economy expanded at a sizzling annual growth rate of 7 per cent in the fourth quarter and is expected to grow by a solid 3 per cent or more throughout this year.

However, actual inflation remains low at 3 per cent and the core inflation rate, which excludes food and energy prices, shows no sign of turning up. Almost all price indicators remain benign. So why all the fuss?

A critical issue is unemployment. It is seen as the best single indicator of when the economy reaches a point, as measured by labour and product markets, of accelerating inflation. This is called the 'natural rate of unemployment'. Recent gains in US employment growth, which is expected to rise to 3.1 million new jobs this year from 2 million last year, has given fresh ammunition to the inflation hawks at the Fed and in the bond markets.

However, several distinguished economists warn that pursuit of such a narrow anti- inflation goal, particularly one as questionable as the 'natural' unemployment rate, risks too much unecessary pain.

The official rate of US unemployment is now at 6.5 per cent. Those who use the natural rate of unemployment as an inflation guide, put it at anywhere from 6 to 6.75 per cent - although the Clinton administration used 5.5 per cent as its guide before recent revisions of the data.

The Nobel Laureate Robert Solow questions whether there is a 'natural' unemployment rate for the US. He further suggests that the US risks contracting 'Europe's disease' if it single-mindedly stalks the inflation threat when no such threat exists.

In a paper entitled Europe's Unnecessary Unemployment, Mr Solow contends that a significant contributing factor to Europe's escalating joblessness since the late 1970s has been a rigid adherence to too-tight monetary policies.

Growing numbers of US economists are now echoing this theme. Chief among them is Alan Blinder, recently nominated to be the Fed's vice- chairman. He argues that failure to reduce unemployment to low levels can be a greater loss of national welfare than letting inflation rise.

Meanwhile, the US economy has a lot to applaud. Consumer demand is rising, the credit crunch has abated, corporate balance sheets look healthier. Perhaps the biggest cause for celebration is the recent surge in productivity growth, which has resulted in barely rising unit labour costs. Output per hour (non-farm) has been rising at a 2 per cent annual rate.

Non-inflationary growth potential is thus seen by many as far higher than in the 1970s and '80s, another good reason the Fed should go carefully.