Did the Federal Reserve go too far in lowering interest rates?

Conventional wisdom says no, but some economists are not so sure. These naysayers think the seven-point rate decline since 1989 has sown the seeds for a mild rebound in inflation.

If they're right, a clash between the Fed and the Clinton administration could be looming. The reason: A surge in inflation would force Fed officials to raise rates. And that would not sit too well with the administration, which is counting on low rates to stoke the expansion and create more jobs.

At the heart of the debate, not surprisingly, is how fast the economy will grow. Most economists are cautious, projecting that, at best, the recovery will continue to be tepid. But others - like John Mueller, chief economist for Lehrman Bell Mueller Cannon Inc., a business forecasting firm in Arlington, Va. - foresee robust growth.

Inflation Seen Heating Up

That factor, coupled with the drop in short-term rates, will set the stage for an inflation spike, they argue. Mr. Mueller sees inflation growing by 4% next year and 4 1/2% in 1995, versus 2.9% last year. And indeed, reports of rising producer and consumer prices two weeks ago caused inflation jitters, though they have since subsided a bit.

"What we're looking at is the result of trying to stimulate the economy with monetary policy," said Mr. Mueller. "Each one of those easings has sent a wave of monetary stimulus through the economy, first through the financial markets, second through the real economy, and now it's showing up in prices."

Last week's reports of rebounding retail sales and housing starts in April are signs that the economy will show more growth in coming months than most people realize, he said.

Worldwide Dollar Watch

Mr. Mueller's firm uses a computer model that includes a measure of money, called the world dollar base, that keeps track of currency and bank reserves held in the United States as well as dollars held by foreign central banks.

The model shows dollars have been been streaming into world markets since 1990, setting the stage for higher commodity prices followed by a general price rise.

"In fighting the recession with monetary policy, the Federal Reserve and other central banks gave a real jolt to the world dollar base in 1990 and early 1991," said Mr. Mueller.

So far, the impact on inflation has been muted by high unemployment and productivity gains by business. But by next year the combination of easy money and an improving economy will be showing up more clearly in the price measures, he warned.

Brian Wesbury, chief economist for the Chigago brokerage firm of Griffin, Kubik, Stephen & Thompson Inc., agreed that Fed officials have gone too far.

"They've dropped short-term interest rates a lot further than inflation has fallen," he said. "I'm really worried that the Fed's been way too easy, and my concern is short-term rates are going to pop up."

Cheap Funds for Banks

Mr. Wesbury said that by setting a federal funds rate of 3%, the Fed is allowing banks to lend to each other on the cheap, adding to inflationary pressures. He sees prices rising by 4% this year and 5% next year, which he thinks would force the Fed to start lifting rates in several months. So far this year, inflation has risen at an annualized rate of 4.3%.

"The longer the Fed waits to tighten, the more upward pressure on nominal growth in the economy, and the more pressure on inflation," he said in a market letter to clients.

Fed officials have dismissed the decline in the money supply this year as a technical shift by investors from bank certificates of deposit to higher-yielding stock and bond funds.

Back into Checking Accounts

But Mr. Wesbury argues that much of the money used to buy mutual funds has filtered back into checking accounts of businesses and individuals and pushed up growth in M1, a narrow measure of money that includes currency in circulation and checkable deposits.

Fed figures show that M1 jumped 8.9% in 1991 and 14.2% in 1992. The monetary base, which includes currency in circulation plus bank reserves, rose 6.3% in 1991 and 8.2% last year.

Banks are not required to set aside reserves for certificates of deposit, but they must do so for M1 deposits. Mr. Wesbury said that as bank demand for funds has increased, the Fed has had to be especially generous in providing reserves to the banking system to keep short-term rates low.

The Bond Buyer is a sister publication of the American Banker.

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