Fighting the Right Foe?

By John Greenwald

Is this any way to treat the most promising recovery in years? With the U.S. economy finally showing solid growth, the Federal Reserve has jacked up short- term interest rates three times since February and is widely expected to raise them again this week. Never before has the Fed moved so aggressively to battle a threat of inflation that few others can see.

Critics of the central bank contend that Fed Chairman Alan Greenspan is jeopardizing the recovery by fighting the wrong war. Not only is inflation dormant, they argue, but Americans are working more efficiently in a fiercer, more global competition. The result is that today's U.S. economy can grow faster with fewer price increases than ever before. "The historic connection between economic growth and inflation has been broken," declares General Mills chairman H. Brewster Atwater Jr., whose company slashed the price of Wheaties 10% earlier this year. "There is very little evidence of any inflation in any of the businesses we see."

Greenspan's approach has its zealous supporters. Allen Sinai, chief economist for Lehman Brothers, applauds the "totally unprecedented" new strategy of pre-emption. "The old way never worked," he says. "It was always too little and too late." Nevertheless, last week's economic news confirmed that the expansion is in scant danger of overheating. Consumer prices rose just 0.1% in April as falling food and fuel expenses offset a jump in medical costs. At the same time, wholesale prices slipped 0.1% overall. "Here we are three years into the recovery and inflation is still declining," says Ross DeVol, an economist with the WEFA Group economic consulting firm. "That is unprecedented in the postwar period." Declares Ed Yardeni, chief economist for the C.J. Lawrence investment firm: "By launching what it calls a pre-emptive strike against inflation, all the Fed has done is perpetrate a meltdown in the stock and bond market and raise the serious risk of dramatically slowing the economy."

In Washington the Clinton Administration has been of two minds about the Fed's actions. While White House officials see no threat of renewed inflation, they would be glad if the Fed's moves kept the economy from growing so rapidly that it peaked before the 1996 election. At the Fed, meanwhile, the expected arrival of Clinton nominees Alan Blinder and Janet Yellen, who could be more tolerant of inflation, has the five holdover members groping for new formulas for battling it. The most draconian of these would raise interest rates whenever unemployment falls below 6.5%. (It now stands at 6.4%.) Such a rigid gimmick has little chance of being adopted. "Decision making relies on data, but increasingly on intuition as well," concedes a Fed insider. "The economy has grown more difficult to read."

Numbers alone do not tell the tale. While unemployment may be declining to a point that once would have led to labor shortages and wage hikes, years of layoffs have created a work force that is happy just to have a job. "The wage-setting mechanisms in this country have broken down for most people," says Larry Mishel, research director of the Washington-based Economic Policy Institute. "When people are still worried about holding on to their jobs or having to move to lower-paying ones, they are not thinking of walking into the boss and demanding a raise."

People have good reason to worry. U.S. layoffs rose to more than 228,000 in the first four months of 1994, according to the Chicago outplacement firm Challenger, Gray & Christmas, up 13% from last year's pace. General Motors alone eliminated 17,000 jobs in the first quarter even though it plans to boost output 5.4% this year. (Such labor cutbacks have not stopped GM, Ford and Chrysler from raising prices on popular models like the Chevrolet pickup and the Jeep Grand Cherokee.) Overall, the hourly output of Detroit's workers has been increasing at an annual rate of 6.5%, while wages have grown just 3%.

Although leaders of AT&T, General Motors and other corporate giants expressed little fear of a slowdown during a business conference last week, higher interest rates have already begun to hurt some industries. With the Fed's moves helping to drive the interest on 30-year, fixed-rate home mortgages from 6.7% in October to 8.7%, builders have lowered their estimates for 1994 housing starts by 4%. At the same time, the flood of mortgage refinancings that put hundreds of millions of dollars in homeowners' pockets has all but dried up, closing off a valuable source of extra cash.

Of course, rising rates have also led some buyers to rush into the market while they can still afford a home. Outside Atlanta, Jim and Amanda Arnold bought a two-story house last month instead of waiting until August as they had intended. "The Fed took the indecision out of home buying," says Jim, who runs a valet-parking service and had to borrow to make the down payment earlier than planned.

In a famous remark during the Korean War, General Omar Bradley warned that expanding that conflict into China would create "the wrong war, at the wrong place, at the wrong time, and with the wrong enemy." Bradley's advice was heeded, and he went on to glory. The course of today's economy will determine whether the Fed's offensive against inflation gives stature to its critics.

With reporting by Bernard Baumohl and Jane Van Tassel/New York, William McWhirter/Detroit and Adam Zagorin/Washington