Blowing Off Some Steam

By Barbara Rudolph

What is going on here? By all accounts, the 5 1/2-year-old economic expansion should be fizzling out. Already ancient by historical standards, the upswing appeared to have suffered a devastating blow when the stock market crashed last October. But, defying expectations, the economy is still running and even blowing off enough steam to inspire fears that it may actually be overheating. Forget about a recession, many economists counsel, and start worrying about inflation. Once a faint and far-off danger, rising prices may now pose the gravest threat to economic stability.

Responding to that threat is the job, as always, of Chairman Alan Greenspan and the other governors of the Federal Reserve. As the person in control of the U.S. money supply, Greenspan has the primary responsibility for preventing a price explosion. Last week he seemed to be moving decisively to cool things down by letting interest rates rise. The so-called federal funds rate, the interest charged on overnight loans among banks and the best day-to-day indicator of Federal Reserve policy, inched up from just under 7% to about 7.25%. In response, major banks hiked the prime lending rate they charge commercial customers from 8.5% to 9%.

That made investors recall the last time the banks raised their prime: Oct. 7, only twelve days before the crash. This time the reaction on Wall Street to rising interest rates was not nearly so violent. On the day the prime went up, the Dow Jones industrial average dropped 37.8 points, to 1965.85, but then it recovered a bit to finish the week at 1990.55.

The crucial question is how high the Fed will let interest rates go in its effort to slow the economy and ward off inflation. The answer will have immense political as well as economic ramifications. In this presidential election year, the Republicans will jawbone the Fed, which now consists solely of Reagan appointees, to keep a lid on interest rates, while the Democrats will watch intently for any signs of partisan policymaking.

The clearest indication that the economy might be expanding too quickly came two weeks ago, when the Labor Department reported that the unemployment rate fell from 5.6% in March to 5.4% in April, its lowest level in 14 years. While the drop was good news to anyone looking for work, many economists were alarmed because they believe that unemployment can fall only so far before inflation starts to accelerate. While no one knows precisely where this "trigger point" is, many economists think it is now no lower than 5.5%. During the Carter Administration, inflation accelerated sharply when unemployment dipped below 6%.

Current statistics provide disturbing evidence that the inflation trigger has been pulled again. In March consumer prices shot up at an annual rate of 6.4%, in contrast to a 4.4% rate for last year. Over the past two months, producer prices rose at about a 6% pace, nearly triple their 2.2% increase in 1987.

The theoretical relationship between falling unemployment and rising inflation has come to be known as the Phillips curve, after English Economist Alden Phillips. In 1958 he marshaled almost a century's worth of data from the British economy to show that falling unemployment drives up wages. Conversely, he asserted, rising joblessness forces wages down. The movement of wages heavily influences the level of inflation. But many experts, including Arthur Rolnick, chief economist of the Federal Reserve Bank in Minneapolis, question whether the Phillips curve works that neatly in the real economy. In the 1950s, the skeptics point out, the economy experienced both low inflation and low unemployment, while in the 1970s, prices kept on jumping even as joblessness rose.

So far in 1988, the falling unemployment rate has not led to dramatic increases in wages. For the first three months of the year, workers' average hourly compensation rose by 3.5%, up only slightly from a 3.2% gain during the fourth quarter of last year. Barry Bosworth, an economist at Washington's Brookings Institution, suggests one reason for the modest wage hikes: "Workers have been mainly concerned about job security." Employees know that companies move production overseas when their labor costs become too high. As a result, during recent negotiations workers have moderated their demands for wage increases in exchange for greater security.

Labor's acquiescent posture could easily change. More and more employees are noticing that their companies' top executives have been taking home hefty salary increases and juicy bonuses. But the average American worker has suffered a 6.5% decline in wages, after adjustment for inflation, during the past decade. At some point, says Bosworth, "workers will begin to focus on that loss." That could lead to demands for substantial pay hikes.

While wage gains have remained moderate, other signs point to strong economic activity that could accelerate inflation. U.S. factories were operating at an average of 82.5% of their total capacity in March, up from 80.3% a year earlier. Some industries, including chemicals and paper, are running at more than 90% of capacity. When production is so strained, shortages develop and prices are likely to surge. Another indication that the economy may be running ahead of itself is the level of corporate profits -- up 24% in the first quarter of the year from the same period in 1987. Business investment expanded at an annual rate of 21% during the first three months of 1988.

While few economists consider the evidence of overheating to be conclusive, many are concerned. Says Lyle Gramley, a former Federal Reserve Board member who is now chief economist of the Mortgage Bankers Association of America: "We don't have an explosion of inflation, but it is clear that the inflationary process is under way." And once inflation gets going, it has a momentum all its own. Last week, for example, Continental Can announced a 14% increase in the price of its aluminum cans. That jump alone may set off a round of increases in the cost of beer, soup and soft drinks, since these products are sold in aluminum containers.

Import prices have been rising especially rapidly because of the weakness of the dollar. When the greenback began falling three years ago, many foreign manufacturers were reluctant to raise their prices on goods sold in the U.S. for fear of losing market share. But in the past few months, their profit margins have been shaved so thin that many of them have hiked their prices. Sony raised the price of its consumer-electronics products about 6% earlier this year. Adding to the inflationary pressure is Americans' powerful thirst for foreign goods. During February the U.S. bought $37.4 billion worth of imported goods, up $2.6 billion from January. As a result, the trade deficit for February increased by 11%, to $13.8 billion, a surprising rise that sent the financial markets into a temporary tailspin.

Still, some economists doubt that growth is too rapid and deny that inflation is about to take off. The gross national product, they point out, expanded at a modest 2.3% annual rate during the first quarter. Concludes Richard Rahn, chief economist of the U.S. Chamber of Commerce: "Fears of inflation are greatly overblown." But that GNP figure, the counterargument goes, may be misleadingly low. It was depressed partly because companies trimmed production to draw down inventories. Besides, consumer spending for the quarter was up 3.8%.

The continuing rise in consumer outlays helped persuade the Federal Reserve Board that the economy was sufficiently strong to absorb an increase in interest rates. It was not an easy decision, though, for Chairman Greenspan. A card-carrying Republican who served as chairman of President Ford's Council of Economic Advisers and worked as an economic adviser to President Reagan, Greenspan is naturally reluctant to do anything that might hurt the chances of Vice President George Bush. But since he took office last August, the Fed chairman has earned high marks for independence and integrity.

A faithful follower of even the most obscure financial indicators ("He knows the guys in the basement of the Bureau of Labor Statistics," says an admirer), Greenspan assumes a centrist position among his fellow Fed governors. Members Manuel Johnson, Edward Kelley and Martha Seger tend to favor supplying sufficient money to permit the economy to grow. Others, including H. Robert Heller and Wayne Angell, are usually more worried about fighting inflation. But it is the Fed's Open Market Committee, its chief policymaking arm, that manages the money supply. Besides Greenspan and the other governors, the Open Market Committee includes presidents of the Federal Reserve Banks, who tend to be inflation watchers.

Fed officials all realize that prices will be easier to control now than six months hence. At the moment, inflation might be contained with moderate interest-rate hikes. Later on, if prices begin to climb swiftly, the Fed might be forced to impose much larger increases in rates. Says John Williamson, senior fellow at the Institute for International Economics: "The lesson all central bankers have learned is that if you don't do what is necessary in the short run, you lose financial confidence, which is very difficult to restore."

As Greenspan strives to curb prices, he will have to watch for trouble in currency markets. A further steep decline in the value of the dollar could fan inflation, since it would cause new increases in the cost of imports. Greenspan apparently hopes to avoid that by allowing a modest rise in U.S. interest rates, which will make dollar-denominated securities more attractive to foreign investors.

The danger is that other major nations, particularly West Germany and Japan, will raise their interest rates along with the U.S. The Japanese economy has been growing at a 4% rate over the past six months, and could face ! inflationary pressures. The West Germans, traditionally fearful of even a whiff of inflation, might boost interest rates to guard against price rises. If many countries tighten up at the same time, the dollar will be no less vulnerable than it is now.

Defending the dollar and restraining inflation will take resolve and courage on the part of the Fed, especially in an election year. But Greenspan can probably muster the necessary determination if he thinks back to the early 1980s, when inflation got completely out of control and it took 20% interest rates to halt the price spiral. No one -- Republican or Democrat -- wants to experience a repeat of that episode.

With reporting by Richard Hornik/Washington and Thomas McCarroll/New York