WASHINGTON -- A Federal Reserve staff study proposed a new policy on interest rates and inflation that could help explain the central bank's latest decision to hold borrowing costs steady.
The theory, put forth in a paper by Fed economists David Wilcox and Athanasios Orphanides and released yesterday, suggests that when inflation is relatively low, as it is now, policy-makers should refrain from raising interest rates to squeeze the price level down further.
While financial markets rallied on news of the report, many analysts worried that if the Federal Reserve Board should adopt the staff paper as policy, that would lead to higher inflation, higher interest rates and slower economic growth in the future.
"We have a worm in the apple regarding the Fed's anti-inflation goal," said William Sullivan, an economist at Dean Witter Reynolds in New York. "It suggests a cadre of policy-makers are responding to political pressures. It will dilute the Fed's inflation-fighting resolve."
But the Fed economists argued just the opposite in a paper explaining what they called a theory of "opportunistic disinflation."
A key conclusion is that when inflation is low, unforeseen recessions will do the job of reducing inflation further without aggressive action by the central bank.
Price levels don't increase much -- or sometimes decline -- during downturns as unemployment rates rise and incomes fall.
The two Fed economists declined comment on their study. Fed spokesman Joseph Coyne said some senior Fed officials agree with the theory while others don't.
Fed Chairman Alan Greenspan will deliver his semiannual economic report to the Senate Banking Committee next Thursday and will likely be questioned about the study.
"The markets are treating [the study] as a plant by the Fed in advance" of Greenspan's testimony, said economist Cary Leahey of Lehman Brothers in New York. "Essentially, they're giving a rea- son for not tightening between meetings."
However, the theory advanced in the study doesn't rule out a decision to raise rates at the Fed's next scheduled policy meeting, Aug. 20, said Lyle Gramley, a former member of the Fed board and now consulting economist to the Mortgage Bankers of America in Washington.
If rates are raised then, he said, it will be because policy-makers want to keep inflation from going up in a stronger-than-expected economy and not because they want to drive down inflation at the risk of recession.
Gramley said the "opportunistic disinflation" theory isn't really new. The term was introduced some time ago by Laurence Meyer, when he was a private economist in St. Louis before he became a Fed governor, to describe the central bank's policy in recent years under Greenspan.
The Fed's policy arm, the Federal Open Market Committee, left the overnight bank lending rate -- the federal funds rate -- unchanged at 5.25 percent last week even though there is evidence the economy may be expanding faster than the Fed thinks desirable.
The funds rate traded yesterday at 5.19 percent, below the Fed's target.
The staff paper said the blunt club of raising the interest rates the Fed controls may not be needed in today's economic environment.
Pub Date: 7/11/96