Fed struggles to balance inflation, unemployment concerns

August 18, 1994|By Louis Uchitelle | Louis Uchitelle,New York Times News Service

NEW YORK -- In raising interest rates on Tuesday, the Federal Reserve invoked a belief that is dogma on Wall Street and often challenged elsewhere -- that the U.S. economy is not capable of moving toward more prosperity now.

That view is not stated so baldly. Softer language is used. The nation does not have enough qualified workers to supply a stronger economy, the argument goes. Nor are there enough factories, machinery and computers, or enough steel and other materials used in manufacturing. So allowing economic growth to continue unchecked will result in too much competition for scarce resources and a lot of inflation.

This is sometimes the case. But there is evidence to suggest that now might be the wrong moment to invoke the "capacity" argument as a justification for raising interest rates to slow the economy.

The National Association of Manufacturers says plenty of elbow room exists for more production. The Federal Reserve's own statistics are not alarming. And even if capacity is running short, some economists, including the Fed's new vice chairman, Alan Blinder, say that not much extra inflation is likely to result.

"My view is that if you have a small overshooting of normal capacity, then you have a small acceleration of inflation," Mr. Blinder said in an interview the week before the Fed decided to make short-term interest rates a half-point higher.

Mr. Blinder, who joined the Fed this summer from President Clinton's Council of Economic Advisers, voted for Tuesday's increase in the Federal funds rate, which banks charge one another for overnight loans, to 4.75 percent from 4.25 percent, and the discount rate, the rate the Fed charges for its own loans to banks, to 4 percent from 3.5 percent.

But his view differs, he said, from the prevailing view on the Fed, that overshooting on capacity by even a small amount will cause a big rise in inflation.

Whatever the viewpoint, everyone -- economists, politicians, business executives, bankers and labor leaders -- agrees on one point. If the Federal Reserve, which has raised interest rates five times this year, gets them high enough, then the economy will slow, capacity will go begging and fewer jobs will be created.

That is where the agreement ends and the debate begins. And with increasing openness it is a debate about the trade-off between jobs and inflation.

"Governments today have only one effective way to control inflation: restrain economic growth," Peter Bernstein, an economic consultant, said. "In cruder terms, this means establishing and maintaining sufficient unemployment to keep labor costs under control."

Of course, if inflation rises fast enough and high enough, it almost certainly becomes a greater evil than the rising unemployment that results from slower economic growth and less use of capacity and people. But is that likely to happen in the coming months?

Mr. Blinder seems less concerned that this will happen than Alan Greenspan, the chairman of the Federal Reserve, who expresses a view widely held on Wall Street: Inflation is likely to accelerate rapidly as more of the nation's capacity is employed, and then it becomes very hard to stop.

Although inflation today is only about 3 percent, the acceleration has begun, says David Jones, chief economist at Aubrey G. Lanston, a Wall Street investment house.

"In this environment, with companies operating at close to full capacity, a little expansion results in a sudden acceleration in inflation," he said.

For millions of investors, inflation, or even the possibility of it, is anathema; it destroys the purchasing power of their savings.

But the assertion that labor capacity is being used up is one that the National Association of Manufacturers, no ally of wage pressures, flatly rejects. The association seldom criticizes the Federal Reserve but did so this week, appealing to the Fed on the eve of its meeting not to raise interest rates.

True, it said, employment is rising and factories are using up more capacity than six months ago -- but there is no shortage of capacity.

"There are large numbers of temporary, part-time and contract workers out there who are counted as employed but are in reality competing for permanent jobs, and they are not making wage demands," said Gordon Richards, a senior economist at the association. "There are enormous amounts of disguised slack in the labor market."

Neither the view that capacity is ample, as Mr. Richards argues, or in short supply, as Mr. Jones believes, is strongly supported -- or undercut -- by government statistics.

Suppose the Fed had not raised rates on Tuesday?

Mr. Jones and others argue the economy would spurt beyond its capacity. And while jobs might be created, inflation would jump.

Then the Federal Reserve's efforts to bring down inflation, through a big increase in interest rates, might create a recession and many of the people who got jobs would lose them. Better to create fewer jobs now and avoid the layoffs later, this argument goes.

But what if the economy were allowed to grow smartly and inflation did not rise strongly? "We don't have great shortages, with people waiting in line, and a let-it-rip approach would lead to only a modest increase in inflation," said Robert Gordon, a Northwestern University economist.

What's more, he added, even if the Fed did not exist, the economy would eventually slow down. "That's the nature of business cycles," Mr. Gordon said.

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