Inflation looms as economic clouds form over Bush. Hikes in prime rate, GNP augur Fed move to cool economy

The economy may be in for a climactic shift. In the three weeks since the election, interest rates have started to ratchet up, and there are signs the Federal Reserve Board is looking at barometric readings it does not like.

Whether Alan Greenspan will rain on George Bush's parade is not yet clear. But as former Federal Reserve Board governor Lyle Gramley notes, the economy is still growing faster than the Fed might like.

``The economy does not need to be slugged over the head with a hammer, but it might need a firmer tug on the reins,'' says Mr. Gramley, now chief economist at the Mortgage Bankers' Association.

An indication of the economy's faster growth came yesterday when the Commerce Department reported that the third quarter gross national product (GNP) - the total sum of goods and services - grew 2.6 percent, a revision upwards from the 2.2 percent reported last month.

If the drought's impact were removed from the statistics, the economy would have grown at a 3.2 percent annual rate - the same as the first six months of the year.

A price index linked to the GNP showed inflation ticking up faster than expected as well. It rose at an annual rate of 4.7 percent, up from the prior estimate of 4.4 percent.

To some economists this is enough evidence to justify further tightening by the Fed. However, Gramley believes the Fed will probably wait until after the government reports the unemployment statistics on Friday. If new job creation continues in the 300,000 range, the Fed will likely raise the discount rate from 6 percent to 7 percent.

It is also likely that the Fed will be keeping a wary eye on the price of crude oil. This past Sunday, the member nations of the Organization of Petroleum Exporting Countries agreed to curtail production in an effort to halt the falling oil price. The drop-off of oil prices had helped to moderate other price hikes.

However, there is considerable skepticism over whether OPEC will be able to rein in its members who have ignored such agreements in the past.

``They prop up the price and then the price softens again,'' notes Robert Dederick, chief economist at Northern Trust Company in Chicago.

If OPEC can cut back on oil production, it is widely expected the price of gasoline will go up by about a nickel a gallon in mid-to-late January.

Even without the Fed using its screwdriver to fine tune the economy, interest rates are rising.

On Monday, most major banks raised their prime interest rate - the rate at which they lend to their best customers - to 10.5 percent. This increase reflected a sharp rise in the cost of short-term borrowing.

Noting that the Fed could have prevented this hike, economist Brian Fabbri of Thomson McKinnon Securities says it shows a ``wily Fed that is saying maybe interest rates ought to go up as a disciplining force on the new administration.''

George Bush, in fact, is likely to hear a similar drum beat today when Paul Volcker, the former chairman of the Fed, is scheduled to testify before the National Economic Commission, the bipartisan group that is supposed to recommend to the President ways to reduce the budget deficit. Mr. Volcker is a well-known advocate of cutting spending.

Policymakers are also sure to be watching holiday sales. Early reports indicate that consumers are not digging deeply into their wallets this season. Many stores are advertising early sales in an effort to get consumers to buy. And the latest GNP numbers indicate inventories rose from the second quarter. This could put pressure on retailers to lower prices even further.

If consumer spending tails off, this might help take some heat off the Fed, says Robert Brusca, chief economist, at Nikko Securities Company International. ``What the economy needs is weaker demand and higher output,'' he says. The higher output is necessary to help produce goods for export to help eliminate the US trade deficit. ``We do have a dilemma. It is tough to fine tune the economy,'' he says.

Concerned that the trade deficit is not improving fast enough, some investors have been selling dollars, putting the greenback under pressure on foreign currency markets in recent weeks.

To help ease this situation, Mr. Fabbri believes the major industrial countries, known at the G-7, will soon convene a special meeting to lower the official range of the dollar against the yen and the mark.

This action would help the Federal Reserve Board and other central banks since they have agreed to purchase all the dollars sold by the investors.

It might also relieve the Fed of the need to raise interest rates to defend the dollar in January. And it would give the Bush administration more time to show what it intends to do to close the budget gap.