Inflation Lurks in the Shadows

For several years, a small group of economists called the Shadow Open Market Committee has forecast slower inflation. They were way out in left field.

Other forecasters were wringing their hands over the prospect of more inflation. They looked at low unemployment rates and busy factories, and said prices would rise faster. Too much demand.

Yet the shadow group was right.

Last week, the group changed its mind, again bucking prevailing wisdom. "The disinflationary progress is now in jeopardy," the group said.

If this is right, it has profound economic importance. Higher inflation would send stock prices tumbling. Interest rates would climb. Bond prices would fall. Workers could see their recent salary gains eaten away by higher prices.

The group isn't saying price indexes will jump right away. One-time events, including lower oil prices, falling import prices, and technical adjustments in the consumer price index (CPI), will "mask" the underlying rate of inflation.

That proves to be the case. The CPI for February was up a tiny 0.1 percent for the month, 1.4 percent over 12 months.

Over the medium or long-term, though, the Federal Reserve risks a reversal of its "progress toward price stability achieved by the proper monetary policies of the last several years," the group says.

The Shadow Open Market Committee, named after the Fed's policymaking Open Market Committee, was launched nearly 25 years ago. It was a time of intense debate among economists between "monetarists" and "neo-Keynesians."

The monetarists said that both inflation and economic growth reflect, with a lag, the growth rate in the money supply.

Money supply is what people use to buy and sell goods and services. The basic money supply (M-1) consists of currency and checkable bank deposits.

It is a recent rise in money supply growth that prompted the shadow group to sound its inflation warning.

Neo-Keynesians put primacy on interest rates in economic forecasting. But the monetarist challenge prompted them to give money considerable importance.

For years, the shadow group criticized the Fed incessantly for paying too little attention to the money supply.

For a brief period, the monetarists won. In the fall of 1979, Fed Chairman Paul Volcker oversaw a monetarist policy - controlling the money supply rather than interest rates. The action brought a severe recession - and less inflation.

Soon the Fed went back to controlling short-term interest rates, rather than money. That proved wise. The nation's financial system in the 1980s and early 1990s changed so rapidly that money was a poor economic predictor.

But now monetarism is having a modest revival. Fed Chairman Alan Greenspan told Congress last month of "tentative signs" of a reassertion of the "historical relationship" between money and the nation's output.

Two monetarists are among Fed policymakers, both former members of the shadow group. Jerry Jordan heads the Fed branch in Cleveland. William Poole was just named president of the St. Louis, Fed, long a monetarist fortress.

One problem is that money has several measures. So monetarists can disagree among themselves. One shadow-group member, Mickey Levy of NationsBanc Montgomery Securities in New York, says he is "a little more sanguine" about inflation than the group. But still figures the Fed "has to think of tightening."

Lawrence Kudlow of American Skandia in Shelton, Conn., says much new money is going to Asia and Eastern Europe. US dollars are in strong demand. So no need to tighten, says the insurance firm economist.

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