Economists challenge Fed's inflation 'hunch'

Economists have had a hard time predicting inflation rates this decade.

"The record hasn't been great," says Dean Baker, an economist with the Preamble Center, a Washington think tank.

So the Federal Reserve is taking something of a gamble if it raises interest rates to slow the economy in a "preemptive" action against inflation.

The risk is that a rate hike - or hikes - could damage the nine-year-old economic expansion in the United States and its accompanying prosperity. It also could clobber stock prices.

But in testimony to Congress last Thursday, Fed Chairman Alan Greenspan all but announced that a "modest" rate hike would be taken at a monetary policy session June 29-30.

To Mr. Baker, the Fed's expected hike in short-term rates of 0.25 percent to 5 percent would be based on a mere "hunch" - not any solid predictive power.

In the minutes of a Fed policymaking session of last February, some participants acknowledged that they had been constantly surprised that inflation had not picked up as unemployment steadily dropped to its present 4.2 percent rate.

Further, in the Fed's semiannual reports to Congress in the last few years, its inflation predictions have been too high.

"Fed officials have been pretty clear in saying that traditional methods of forecasting inflation are not serving us well," notes Thomas Schlesinger, executive director of the Financial Market Center in Philomont, Va.

Mr. Greenspan admitted that guiding monetary policy by its present models of the economy "would have unduly inhibited what has been a remarkable run of economic prosperity."

But many in the financial community have great confidence in the judgment calls of Greenspan.

Both stock and bond prices rose after his strong hint of a rate hike ahead.

"If the goal is to prevent or limit a rise in inflation, since monetary policy works with a lag, it is prudent to start imposing some restraint now," says Paul Kasriel, an economist with Northern Trust Co., Chicago.

Even those Fed watchers keen on low interest rates as a way to help low-income workers win bigger wage increases praise Greenspan for letting the jobless rate fall so low.

Greenspan's rationale for a preemptive move is that "certain imbalances" in the economy pose a risk to the longer-run outlook. But he acknowledged that an acceleration in productivity resulted in an underprediction of economic growth and an overprediction of inflation, and that labor-market tightness has not yet put the expansion at risk.

"Inflationary pressures still seem well contained," he said.

Nonetheless, he saw a danger that a growing scarcity of workers could provoke large inflationary wage gains.

And, he added, because higher interest rates take time to slow the economy, "we have to make judgments ... about how the economy is likely to fare a year or more in the future under the current policy stance."

In effect, he pronounced a speed limit for the economy of 3 percent growth in national output after inflation. But output grew almost 4 percent last year and even faster than that in the first quarter of this year.

Those hoping the Fed will not put on the brakes, offer at least three counterarguments:

1. The lag between Fed braking and the economy slowing is short. So the Fed can afford to wait for more inflation to appear.

Some impact of an interest-rate hike takes place in two months, though the full impact may take 18 months or two years, says Baker.

2. Rapid inflation doesn't spring forth full-blown.

"It grows incrementally," says Mr. Schlesinger. So the Fed has some time to restrain it.

James Galbraith, an economist at the University of Texas, Austin, says the Fed could allow the unemployment rate to fall even further, 0.1 percentage point at a time, and then see if inflation starts to accelerate. "Watch what happens," he says.

3. Though there are some signs of recovery abroad, the world economy is still shaky.

"The US cannot consider itself in isolation," says Gordon Richards, an economist of the National Association of Manufacturers in Washington. "It must create dollar liquidity for the world."

But Greenspan sees inflation as a danger to prosperity. "Our responsibility," he said, "is to create the conditions most likely to preserve and extend the expansion."