Nipping inflation in the bud could avoid more drastic pruning later on

A DEBATE has begun in Washington that echoes those of earlier years: Is it better to combat inflation with economic policies of ``gradualism'' or go ``cold turkey.'' In the first four months of this year, consumer prices have been rising at a serious 6 percent annual rate.

The consensus view among economists is less alarming. According to the latest monthly survey of some 51 top economists by Blue Chip Economic Indicators, inflation for all of 1987 will amount to 3.8 percent and next year 4.5 percent. That average, though, has been creeping upward over the months.

Some economists are even more pessimistic.

For example, Lacy H. Hunt, chief economist at the CM&M Group, talks of inflation accelerating to an annual rate of 6.5 percent in the second half and 7.2 percent rate next year. He bases such a gloomy forecast partly on the basis of a rise of 30 percent in spot industrial commodity prices since last August.

Another reason for growing concern about inflation has been the rapid increase in the nation's money supply.

``Inflation is primarily a monetary problem,'' says Lawrence A. Kudlow, chief economist at Bear, Stearns & Co. ``Price indexes in the US are rising because monetary policy is too loose. If left unchecked, continuation of the current cheap money policy will lead to even more rapid inflation and higher interest rates during the months ahead.''

Sensing this prospect, investors are already demanding higher interest rates. The dollar is not only losing purchasing value at home, but dropping in price on the foreign exchange markets.

When the seven leaders of the industrial nations concluded their economic summit in Venice last week, they announced their support of the dollar and Japanese Prime Minister Yasuhiro Nakasone spoke of lowering interest rates. The Treasury bill and bond markets paid attention momentarily. Then prices fell back again.

It was a signal that government leaders' statements are losing credibility among investors.

What's to be done about inflation?

In the past, the Federal Reserve has usually followed a policy of ``gradualism,'' that is, making very small but frequent adjustments in interest rates in an attempt to slow the economy down and dampen inflation. Proponents of gradualism believe it enables the Fed to avoid acting rashly and possibly avoid pushing the economy into an unnecessary recession.

Gradualism was tried in periods of rising inflation, both in the early and later phases of the Vietnam War, during 1972-73 under President Nixon, and in 1977-79 under President Carter.

In each case, notes economist Hunt, gradualism failed. Inflation accelerated and interest rates rose.

Nor did gradualism prevent recession. Actually, says Mr. Hunt, it may have resulted in more severe downturns. Because inflation got worse under gradualism, the Fed eventually had to put on the brakes harder.

``All gradualism does is prolong the agony,'' says Mr. Kudlow. He is an advocate of decisive monetary tightening action by the Fed, sometimes called ``cold turkey,'' a phrase originally designating the complete withdrawal of drugs from an addict.

Kudlow indeed urges the Fed to remove around $5 billion in reserves from the banking system immediately. He suspects that will boost interest rates temporarily by up to 1 percentage point.

But because the Fed has been printing money at historically high rates for two years, he figures that won't prompt an economic downturn. In addition, the velocity of money - how often it changes hands - has started to grow again; whereas, it had been negative. That, too, means less money is needed to keep the economy growing.

``Action today will be much less harmful to interest rates than postponing the action six or 12 months,'' he says. It will dampen the rebirth of inflationary psychology and help stabilize the dollar.

But if nothing is done, he says, a 2 to 3 percent jump in interest rates in the near future might be needed to have the same dampening impact on inflation.

Hunt also advocates ``decisive action'' now, but would prefer to see some more solid measures to slash the federal budget deficit.

Alan Greenspan, nominated last week by President Reagan to succeed Paul Volcker as chairman of the Federal Reserve, is certainly aware of the inflationary danger arising from the rapid expansion of the money supply.

In an interview with Business Week about three months ago, he was already saying, ``I have a suspicion that when we look back at this period, we'll probably think we allowed more monetary expansion than was appropriate.''

Whether he will urge gradualism or cold turkey at the Fed when he arrives there later this summer remains to be seen. The issue is already being debated in the councils of the White House.