Thanks for the Slowdown, But Did We Really Need It?

AS the economy continues to slip and the possibility of recession looms larger, more people inevitably will begin to question the policies of the Federal Reserve Board.

As well they should. After all, the Fed made no effort to conceal its aims when it began raising interest rates in February 1994. Its goal was to slow the economy. Before a year was past, the Fed had racked up seven increases, doubling short-term rates.

To no one's surprise, the contractionary monetary policy has had its intended effect. A parade of bad news on the economy in recent weeks - payroll jobs figures, leading economic indicators, auto production, retail sales, productivity, and durable goods orders - indicate that the Fed's mission has been accomplished. The only question is, why?

In the Fed's view, the 4 percent annual economic growth of 1994 was not "sustainable." In other words, if the economy continued to grow at that pace, there would be an increase in the rate of inflation. The underlying theory is that shortages of labor, materials, and manufacturing capacity will drive up prices.

If unemployment falls below its so-called "natural rate," inflation must increase. (The Fed sees this "natural rate" as about 6 percent.) The idea is that as labor markets tighten, workers can demand and get higher wages. These higher wage costs are then passed on by businesses in the form of higher prices. The Fed's nightmare scenario is that the higher prices then cause still higher wage demands, and the process spins out of control, an "inflationary wage-price spiral."

There are problems with this argument. First, there wasn't much of a threat of inflation when the Fed began its preemptive strike: The Consumer Price Index measured inflation at 2.4 percent.

More important, the Fed's theory doesn't measure up against the historical evidence. During the 1960s the average unemployment rate was 4.8 percent, while inflation was only 2.3 percent. If anything, economic globalization in the last two decades has provided United States corporations with additional capacity and (often cheap) labor to expand production without price increases.

There is no compelling evidence that any of the serious inflationary episodes of the past 50 years were caused by the kind of "wage-price spiral" that haunts the Fed. The inflation of the 1970s, for example, is generally agreed to have been launched by OPEC's sharp increase in oil prices.

THERE is always some risk of increasing inflation whenever the economy grows and unemployment shrinks. Bond traders are well aware of this, and since any increase in actual or expected inflation erodes the value of bonds, any good news about the economy generally prompts a sell-off in the bond market. That's perfectly rational behavior. The problem for the rest of us is that the Fed appears to have adopted the perspective of the bondholders and acted accordingly.

This question of how to view the trade-off between unemployment and inflation is anything but academic. While the average household would gladly accept even a full percentage point of extra inflation if it allowed the economy to create a million new jobs, this is not so for big bondholders. For them, inflation is the only enemy. The Fed's allegiance to their interests may be hazardous to our economic well-being.

Although the unemployment rate is now 5.7 percent, below the Fed's "natural rate," there are about 7.5 million officially unemployed seeking work. Their numbers will swell as the economy continues to slow.

The impact of the Fed's policy spreads far beyond the unemployed. In 1994, the majority of wage earners actually saw their real weekly earnings fall, despite the fact that this was more than two years into an economic recovery. This phenomenon - falling real earnings for the majority while the economy grows - is something we never used to have to worry about. But the Fed's commitment to slow growth and historically high unemployment levels helps make it a reality.

If you're flying from San Francisco to New York, you don't necessarily want to land in Nevada, softly or otherwise.

The Fed assumes we can't make the same journey that our economy has been capable of for most of the past 50 years. Maybe it's time for another look at the instrument panel - and perhaps a new pilot.