If Fed Doesn't Goof: Growth, Zero Inflation

ECONOMIST Allan Meltzer sees an extraordinary opportunity for the United States economy. "If we don't mess up, we are at the point where we can get back to growth without inflation," the Carnegie-Mellon University professor says.

The last time the US enjoyed such an ideal scenario was in the years after World War II until about 1965 when the Vietnam conflict became expensive. Higher spending on that war was not paid for by raising taxes. So inflation began to step up its pace. With the Organization of Petroleum Exporting Countries' quadrupling of oil prices from 1973-74 and weak monetary policy, inflation has been unbeaten since then.

Dr. Meltzer's "mess up" warning refers to the Federal Reserve's monetary policy. He would like the Fed to "move decisively" to lower interest rates at its July 5-6 meeting, if not sooner, to avoid worsening the current slowdown in the economy. The economy is close enough to recession that "we should be concerned," he says. After noting that forecasting the economy is "more of an art than a science," he speaks of the possibility of the economy shrinking in real terms this quarter and next.

Meltzer is chairman of a nongovernmental group of eight academic and business economists who form the Shadow Open Market Committee. Named after the Fed's policymaking body, the group meets twice a year in Washington to review monetary policy, criticize it, and make suggestions.

Founded in 1973, the group is "monetarist" in its leaning - that is, the economists pay close attention to the so-called "monetary aggregates," such as the "monetary base" (currency plus bank reserves) and the basic money supply (currency, demand deposits, and other checkable deposits). Trends in these aggregates, monetarists hold, predict what will happen to inflation and real economic growth after a lag of nine months or longer. This school of economists lost much clout when their predictions, which had been relatively accurate in the 1960s and '70s, didn't always pan out in the 1980s.

The Fed itself abandoned a three-year policy of basing monetary policy on the monetary aggregates in October 1992 - "mainly because of increasingly significant practical problems in defining the money supply accurately in a period of rapid technological and institutional change and financial innovation - a problem that has continued to this day," writes J. Alfred Broaddus Jr., president of the Fed's branch in Richmond, Va.

Yet the Shadow committee's meetings still attract about 40 congressional staffers, newspaper reporters, and TV crews.

"Monetarism is going to come back into style," Meltzer says.

One reason is that the Shadow committee's forecasts are proving sounder this year. Most economists predicted a modest economic slowdown in 1995 but no recession. The Shadow committee told the Fed last September that it had done a good job in starting to raise interest rates the previous February in an effort to prevent a rebirth of inflation, but that it should stop tightening monetary policy further while awaiting the lagged impact on the economy of that action. The Fed continued to raise interest rates further. Bank reserves have been shrinking. The basic money supply has not grown for a year - an unusually long time for not adding monetary fuel to the economy.

At its March meeting, the Shadow group warned the Fed that it had "done too much."

One of the advantages of this group, Meltzer jokes, is that "you get to tell the Fed, 'I told you so.' " And "forget" mistakes.

Meltzer is especially proud of the Shadow group's inflation-forecasting record. Its average error is three-quarters the size of the error of a model based on interest rates maintained by the Federal Reserve Bank of Atlanta, he says.

Meltzer wants the Fed to lower short-term interest rates by 0.5 percent and wait a month to see if that is enough to revive growth in the monetary base - and eventually pep up the economy. If not, it should lower rates further. He expects inflation this year to run slightly above 2 percent and only 1 percent next year. Because of a measurement problem, 1 percent is "essentially zero."

Meltzer, who began working on monetary issues in 1960, says Fed chairman Alan Greenspan is conducting "the best monetary policy in my lifetime."

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