How inflation could thwart US economy's recovery

When the Federal Reserve cut interest rates another half percentage point April 18, Wall Street cheered.

Stock prices soared. Happy days are here again - or nearly here, many investors figured. Good for the Fed. A little more interest-rate reduction, please, sir, Mr. Alan Greenspan.

But a relatively small group of economists is booing. They say the Fed has overdone monetary ease. As a result, somewhat more inflation lies ahead.

The Fed "has lost sight of its long-run objective of price stability," charged the Shadow Open Market Committee last week. This group of economists was set up in 1973 to "shadow" the Open Market Committee of the Fed, which sets the nation's short-term interest rates and monetary policy.

The SOMC's eight economist members are primarily "monetarist" - holding that the supply of money to the economy determines the future inflation rate, and, to a degree, the pattern of the business cycle.

"Monetary over-management and attempts at fine tuning [the economy] create poor and erratic economic performance and raise the danger of a return to the 'stop-go' policies that produced the stagflation of the 1970s," the SOMC states.

It disapproves of the surprise interest-rate cuts that the Fed made twice this year between its regularly scheduled policy sessions. It further charges Fed policymakers with "constantly-changing explanations" for its rate cuts. These actions are "destabilizing," the SOMC holds.

To monetarists, the US would be better off if the Fed put monetary policy on something close to automatic pilot. The Fed should hold to a 3 to 5 percent steady growth rate of what is known as the "monetary base." This is the total of bank reserves, which the Fed can control, and currency.

Such a policy, monetarists say, would keep inflation modest and dampen the ups and downs of the economy.

Right now, the monetary base has accelerated to a 5.7 percent annual growth rate. When the Fed pumps money into the banking system, it becomes in a way a legal counterfeiter. Figuratively, it creates new money out of thin air. And money is the fuel for economic growth.

Paul Kasriel, an economist with Northern Trust Co. in Chicago, notes that M2, a measure of money that includes checking deposits, currency, some savings, and money-market deposits and funds has been growing at a rapid 13.6 percent annual rate in the past 13 weeks.

This is good news in one way.

Over the past 40 years, growth in M2, when adjusted for inflation, has been a rather reliable leading indicator of after-inflation growth in the nation's economy some two quarters into the future.

A chart drawn up by Mr. Kasriel shows that to be the case, except for a period in the early 1990s when banks were suffering a surfeit of bad loans.

Kasriel says M2 is "a heck of a lot better [indicator] than these new-fangled financial-conditions indexes" touted by some Wall Street investment houses.

Fed Chairman Greenspan puts less trust in money as an indicator.

If M2 does hold up as a leading indicator now, with the banks again sound, the economy should pick up speed in the second half of this year. But so could the inflation rate. "The costs of rising inflation far exceed the illusory benefits of attempts to fine-tune the real economy," warns the SOMC.

"It's not the end of the world yet," says SOMC cochair Charles Plosser, dean of the University of Rochester's business school. But he has less confidence in Fed policy than he had, "say a year ago."

During the first quarter of this year, the consumer price index grew at a 4 percent annual rate. That's up from 3.2 percent in 2000, 2.7 percent in 1999, and 1.6 percent in 1998.

"The trend in inflation is up by almost every measure," says the SOMC.

Kasriel holds that stagflation - in which prices rise despite slow economic growth - is already here. The economy grew at a 2 percent annual rate in the first quarter. A measure of economy-wide inflation, the deflator, rose faster at a 3.2 percent rate.

Mr. Plosser says the Fed has cut interest rates "too much and too fast."

Many in the financial community disagree. They count on the Fed knocking down short-term rates either 0.25 or 0.5 percentage points May 15. Merrill Lynch economist Bruce Steinberg expects even more cuts this summer to get rates down to 3.5 percent.

"The Fed still has more work to do," says Lawrence Kudlow, a Wall Street economist.

He doesn't expect full economic recovery until next year, but says the stock-market rally that usually precedes an economic upturn "has already begun."

(c) Copyright 2001. The Christian Science Monitor