Rates in the balance

LLOYD BENTSEN, the US Treasury Secretary, seemed to speak in error when he let it be known that his own forecasters expect US interest rates to rise in the first quarter despite continued good news on the inflation front.

His remarks triggered immediate responses from inhabitants of the White House and the business community, who declared that a continued policy of low interest rates is in the best interest of the recovering economy. President Clinton had earlier asserted that it would be 'inappropriate for the Federal Reserve to raise interest rates' now.

So why the current flurry of interest rate speculation, particularly among private economists who agree that the Federal Reserve will raise short-term US rates very soon as a pre-emptive strike against inflation?

The interest rate debate is centred on the nature and scope of the current recovery, which appeared stronger than expected in the fourth quarter, with growth projected at between 4 and 5 per cent. Mr Bentsen also said, however, that inflation remained at the lowest level in many years, at about 2.8 per cent. Traditionalists, citing US growth and a reduction in the jobless rate to 6.5 per cent from 7.25 per cent in early 1992, maintain that the Fed must act now rather than wait for an outbreak of inflation by 1995.

Lyle Gramley, a former Fed governor, is one of the traditionalists recently polled by the Wall Street Journal who contends that the rate of monetary growth should be cut from 10 per cent to 5 per cent by the end of this year. His argument is based on the still widespread belief that US unemployment is approaching the 6 per cent level, which is as close to 'full employment' as the economy can get without igniting a round of inflation.

Others who point to the two-tier nature of the current recovery - with one tier of companies growing fast enough to create jobs but another tier of larger companies still in difficult reorganisations - see inflation looming on a different front.

According to some respected regional bank economists, many US companies cut back too much during the difficult years. The result is that, in some key industries and product lines, inventories are too sparse to service the needs of a recovering economy. The fear is this will put upward pressure on prices.

However, there is as yet no firm evidence that inflation is either picking up smartly or moving into a danger zone. Rather, the reverse is true.

Short-term interest rates have risen slightly in recent weeks in response to market forces. The Treasury expects but does not want additional increases in short-term rates over the next two quarters. Indeed, Mr Bentsen, who plays up the administration's role in generating this recovery by providing the climate for dramatically lower interest rates, said the challenge this year will be to 'achieve a solid 3 per cent real growth and hold inflation to approximately 3 per cent'. It is doubtful such growth will be achieved if the Fed takes Mr Gramley's advice and cuts monetary growth to 5 per cent by the year end, based on fears of full employment fuelling inflation.

The Fed's dramatic easing of monetary restraints, which has led to the lowest interest rates in decades, clearly engineered the current recovery. It is not at all clear that the job is complete, nor is it clear that the Fed should now move from a very accommodating stance to a more neutral one. In the US, as in Europe this year, getting interest rates right will be the critical test. And erring on the low side is in the best interest of all.

It is fair to say that Europe will not recover from the current recession and unemployment will not be reduced without a comprehensive cut in short-term interest rates of about 3 per cent as soon as possible. The European Union's draft strategy to combat unemployment apparently calls for just such an approach, albeit conditional on wage curbs and deficit targets.

Economist John Williamson argues that Europe needs a real short-term interest rate of around zero and a positively sloped yield curve, meaning a lower short-term than long-term interest rate. But hardly any European country has met these conditions over the past two years. Mr Williamson argues that the yield curve remains negatively sloped in almost every country except Britain. Germany and Switzerland appear to have achieved short-term rates below the magic 3 per cent level. Europe's interest rate challenge is very clear.

The US challenge is less clear - indicating sleepless nights and difficult moments for Fed members. The hope is to avoid the start-stop growth cycles that have occurred over the past two years, keeping in mind that tax increases and the effects of President Clinton's deficit reduction programme will cut into growth this year.

In addition, although the balance sheets of US companies are on the mend, there are still many in need of repair, as was recently stated publicly by Alan Greenspan, the Fed chairman. A further consideration is that traditional norms do not necessarily apply in a global economy; the fact that some domestic inventories look too lean does not take into account the excess of goods and services worldwide. It is also true that using unemployment targets as guides to tightening monetary policy, as in the 'Phillips curve' philosophy of the 1950s, may be a very outdated concept.