WASHINGTON - Federal Reserve Board Chairman Alan Greenspan and his colleagues have a chance tomorrow to prove their mettle as central bankers.
The question is whether they'll deliver what the bond market is hoping for - a solid boost in the federal funds rate to 4.25% from 3.75% instead of the usual dollop of 25 basis points that they've sprinkled on the economy the last three times they tightened credit.
The members of the Federal Open Market Committee also have a chance to send a global message of their resolve to defend the dollar by lifting the discount rate to 3.50% from 3%.
The alternative - one that some analysts say is still possible - would be to repeat the pattern of past tightenings and raise the federal funds rate to 4%. Such a move, however, would still leave the market unsettled and looking for more.
No one, it seems, expects the central bank to stand pat despite a continuing series of government reports showing that inflation is going nowhere fast. On Friday, the Labor Department reported that the consumer price index rose only 0.1% in April. Compared to a year earlier, prices were up a trim 2.4%, the smallest year-over-year gain since February 1987.
It is this favorable inflation back-drop that gives Fed policymakers a chance to win back some credibility in the bond market after being accused of moving too slowly to restrain credit. That could in turn stabilize long-term rates and help prolong a moderate expansion, something the Clinton Administration would like to see.
Fed policymakers have made it clear, beginning with Greenspan's testimony to Congress early in the year, that they intend to set a "neutral" monetary policy. The aim is to get interest rates to the point where they are no longer fueling economic growth, but that, ideally, allow the economy to grow as fast as possible without rekindling inflation.
It is an attempt to set a forward-looking monetary policy and avoid the mistakes of the past, when the central bank waited for inflation to pick up before boosting rates and then had to make up for lost ground. Greenspan has said that he is acting now to head off inflation in 1995, when the economies of Europe and Japan are expected to be stronger and adding to demand for credit and U.S. made products.
No one knows exactly what a neutral monetary policy means in terms of short-term rates, but many economists say that history suggests a federal funds rate about 1.5 percentage points over the inflation rate. A federal funds rate of 4.25% would reach the Fed's frontier of policy neutrality.
"The Fed has an opportunity to declare monetary policy neutrality and call a temporary cease-fire in its attack on the debt markets," said Paul Kasriel, an economist with Northern Trust Co. in Chicago.
"The Fed quite rightly has said that inflation is a lagging and not a leading indicator, and so the good news we're seeing now doesn't guarantee we're going to continue to see good numbers on inflation as we get into the second half of the year," Kasriel said. The bond market, he said, "is fully priced for a move of 50 basis points."
A bold rate move by the Fed offers several tantalizing benefits,analysts said. By signaling support for the dollar, it might bring foreign investors back into the bond market and put a lid on rates. A stronger dollar also helps to contain inflation by strengthening the ability of consumers to pay for imports.
Perhaps most important, if investors concluded that Fed officials have achieved their short-term objective, market worries over further rate increases might go away for a while. The Fed and the market could take a breather to see whether the economy cools a bit.
Already, there is evidence that the Fed's policy of raising rates is starting to bite. The Federal Home Loan Mortgage Corp. reported last week that the 30-year fixed-rate mortgage climbed to 8.77%, the highest in two years. And the Mortgage Bankers Association has been tracking a downturn in home loan applications and a steep decline in refinancings that have put cash in consumer pockets.
Politically, the Fed remains under pressure in Congress not to move too quickly in raising rates. At the recent Senate Banking Committee nomination hearing for Alan Blinder, President Clinton's pick for Fed vice chairman, Sen. Paul Sarbanes, D-Md., waved around a Business Week issue challenging the notion that strong economic growth will bring higher inflation.
Treasury Secretary Lloyd Bentsen suggested on Friday that the administration and the Fed remain on amicable terms. "Alan Greenspan and I share the goal of steady, well-grounded, low-inflationary growth," Bentsen said in a speech in Williamsburg, Va. "I think that's what we have, and the Fed is just being cautious to make certain it stays that way."
Not everyone agrees that the economy's pace is close to building up inflationary pressures. Analysts at Merrill Lynch & Co. are forecasting that the economy will grow 4% this year while prices remain largely under control.
Some analysts also question the notion that the dollar is caught in an international crisis that demands higher U.S. rates to lure foreign investors They note that on the Fed's trade-weighted index against a basket of major currencies, the dollar has held its own in the last few years.
The economic outlook is also not a sure bet, some analysts said. While many economists estimate that gross domestic product in the second quarter will post a hefty gain of 4%, some are less certain. In that case, Fed officials have to be careful that they do not go too far. Indeed, fast week's weaker-than-expected retail sales report for April and a rise in jobless claims in early May suggested the economy is already losing some steam.