Tuesday, March 31, 1998

Monetary policy makers poised to meet inflation head on

Fed won't desert its post

Martin and Kathleen Feldstein

THE GOOD NEWS IN THE latest labor market statistics is the continuing growth of employment and the decline of the unemployment rate to 4.6 percent for February.

But the tight labor market could mean bad news later if rising labor costs lead to higher inflation. That could create a need for a future tightening in monetary policy that would push the economy into recession.

The key question, therefore, that the Federal Reserve faces at its Open Market Committee meeting today is whether interest rates should be raised a small amount to reduce the inflationary pressure in the labor market.

The most recent wage and productivity figures provide the basic ingredients for a case for some monetary policy tightening and a rise in interest rates.

Department of Labor statistics show average hourly earnings rose by 0.6 percent between January and February, equivalent to a 7 percent annual rate of increase. With productivity rising at an annual rate of about 2 percent, that translates to a rise in unit labor costs of about 5 percent and, therefore, a potential inflation rate of about 5 percent.

That would be a dramatic and unacceptable rise from the recent inflation rate of less than 2 percent.

Fortunately, the recent surge in average hourly earnings is much more likely to be a temporary aberration than a permanent increase in wage inflation.

Inflation depends, of course, on more than the pressure of wage costs. External factors are helping to keep inflation below where it would be on the basis of wages alone. Import costs fell nearly 5 percent last year and will continue to fall in 1998 as the sharp currency declines in Southeast Asia and in Korea are translated into lower import prices.

The dramatic 33 percent decline in oil prices over the last year contributed to the lower overall cost of US imports.

The reduction in world oil prices also forces the price of domestic oil lower and brings down the prices of substitute fuels such as natural gas.

Electricity deregulation will contribute to lower energy costs and, therefore, lower inflation in 1998.

We also expect a slowdown in the very rapid rate of growth that the economy experienced in the past year, with real gross domestic product rising by 3.8 percent between the final quarter of 1996 and the final quarter of 1997. There will be some slackening from weaker US exports and the increasing substitution of imports for US production.

Business investment in plant and equipment is also likely to be slowing. This abatement in economic activity will mean slower growth of employment demand and reduced pressure on wages.

All of which says the Federal Reserves monetary policy may be about right. The Feds key policy interest rate, the federal funds rate, is now 5.5 percent. With consumer prices up less than 2 percent in the past 12 months, that translates into a real net-of-inflation federal funds rate of about 3.5 percent.

Thats a higher real federal funds rate than in any year since 1960 -- not including the early 1980s, when the Fed was struggling to end double-digit inflation.

Looking ahead, what gives us comfort that inflation will remain low is our belief that the Fed would act quickly to raise the federal funds rate by an adequate amount if inflation began to rise.

The big mistake that allowed inflation to rise out of control in the 1960s and '70s was that the Fed was too timid in its response to rising inflation. Although the federal funds rate was raised when inflation rose, the Fed-determined rise in the interest rate was not big enough. As a result, the real net-of-inflation rate actually fell and the pressures of demand became even stronger.

But the experience during the Volcker and Greenspan regimes at the Federal Reserve suggests that they understand that inflation should be met by a rise in the real federal funds rate.

That means that each 1-percentage-point rise in inflation should cause the nominal federal funds rate to increase by more than 1 percent.

Bill Poole, who was recently named president of the St. Louis Fed, is the newest member of the Feds Open Market Committee. A well-known monetary economist who favors a zero-inflation goal, Poole will strengthen the hand of the inflation hawks on the committee.

As long as the Fed stands by its current policy, we wont have a return to the level of high inflation and subsequent massive recession that spoiled so much of the 1970s and early '80s.

Martin Feldstein, the former chairman of the Council of Economic Advisers, and his wife, Kathleen, also an economist, write frequently together on economics.