The Shadow Open Market Committee, a group of private economists warned this week in the statement excerpted here that the Fed's tight-money policy could throw the economy into recession.
The committee's members, in addition to the three pictured at right, are Charles D. Plosser of the University of Rochester, William Poole of Brown University, Robert H. Rasche of Michigan State University, and Anna J. Schwartz of the National Bureau of Economic Research. The chairman is Allan H. Meltzer of Carnegie Mellon University.
For the first time in 30 years, the United States can achieve stable growth and low inflation in the near term. This desirable result will be realized if the Federal Reserve does not overreact, as it often has in the past. This result will be sustained if the Federal Reserve maintains a firm commitment to a noninflationary monetary policy.
Currently, two different monetary forces pull and push the economy. Excessively rapid money growth from 1991 through 1993 gave momentum to the expansion in the second half of 1993 and 1994.
Decisive slowing of monetary growth in 1994 improved the prospects of a "soft landing" in 1995. There is no law of economics that says that expansions get old and die. Policies that reinforce the stabilizing properties of a free-market economy sustain growth and low inflation.
The Federal Reserve has often overreacted to current events during both expansions and recessions. Typically, the money growth rate rose during recessions and remained high during the recovery. When inflation rose, the Federal Reserve slowed money growth sharply.
Money growth continued low until after a recession had begun. This pattern produced rising inflation and contributed to several postwar recessions. Since 1973, we have urged the Federal Reserve to end this stop- and-go policy.
This cycle is different. The Federal Reserve responded more slowly to excessive growth of the monetary base - bank reserves and currency - than we wanted, but it responded earlier than in most postwar recoveries, before inflation began to rise. Moreover, it responded decisively.
Growth of the monetary base calculated by the Federal Reserve Bank of St. Louis fell from 10% or more in 1992 and 1993 to 7.6% in 1994. In the last year bank reserves declined. The current rate of base growth is consistent with a return to price stability in the years ahead.
At our September meeting, we recommended that Federal Reserve officials reduce growth of the monetary base to 7%. We now recommend that they maintain a 7% growth rate of the base. The Federal funds rate should move up or down as needed to maintain this policy.
*Where is the inflation? Monetary effects on inflation and growth are not instantaneous. Federal Monetary policy works with a lag. If the Federal Reserve had been slower to act in 1994, inflation would be higher now. If the Federal Reserve continues to tighten and reduces base money growth in 1995, the probability of a recession in 1996 will increase.
We expect inflation to increase modestly in 1995 in response to past excessive monetary stimulus. Current policy can do little about near-term inflation, and an attempt to roll back near-term inflation will jeopardize the attainment of stability with low inflation.
The reduction in unemployment in 1994 alerted many to the dangers of inflation. But both inflation and unemployment are lagging indicators.
Looking at the unemployment rate to predict inflation is like driving with your eyes on the rearview mirror; you see where the economy has been, not where it is headed.
Further, there is considerable uncertainty about the level of the so- called natural rate of unemployment at which inflation begins to increase. Unemployment statistics have been revised and are possibly subject to larger errors than usual. For these reasons alone, it is a mistake to predict inflation from unemployment.
Inflation is a monetary problem - not a result of real growth or high employment. The job of the Federal Reserve is to prevent inflation, not to curtail growth and employment. It does its job best by controlling money, not by adjusting policy in response to growth.
*Money growth unreliable? Part of the current folklore teaches that the relation of the monetary aggregates to inflation and nominal output growth has broken down and that money does not matter. The record does not support that view.
We accept that monetary aggregates have been misleading at times. They overestimated inflation in the mid-1980s. The shadow committee's recent record, using the monetary base, runs counter to the popular belief, however.
In September 1991, we forecast that the recovery would be moderate, as it was for more than a year.
In March 1993, we noted that money growth had remained too high for too long. We suggested that economic activity would accelerate and that inflation would increase eventually to about a 4% annual rate.
In September 1993, we argued that the Federal Reserve had waited too long to slow money growth and suggested that long-term interest rates were likely to rise as the rate of economic expansion increased. Interest rates began rising in the fourth quarter.
In September 1994, we expected that economic activity would slow but that inflation would rise near-term. We urged the Federal Reserve to avoid excessive tightening and to follow our practice of targeting the monetary base.
We repeat these warnings and predictions to show that monetary aggregates convey useful information about future inflation and nominal growth. We do not suggest that the Federal Reserve rely on short-term forecasts.
We urge policymakers instead to take a long-term view and pay attention also to the lags in the effect of monetary policy. They should meet less often and improve control of the growth of the monetary base to reduce variability and prevent inflation.
*The dollar. In 1994, the dollar exchange rate fell about 10% against the yen and the mark despite the strong U.S. economy. This continues a long-term decline. Since 1971, the dollar has depreciated about 65% against the mark and more than 70% against the yen.
Dollar depreciation is not primarily a monetary problem. The Federal Reserve cannot do much to stop the decline and should not try.
Those who want fixed exchange rates or coordinated policies to manage exchange rates never take account of the persistent real decline of the dollar against the yen and the Swiss franc. They do not recognize that differences in expected real returns to investment and expected productivity growth also affect change.
The new Congress can do much to strengthen the dollar. Reduced regulation lowers costs and prices. Tax policy that shifts resources from consumption to investment by reducing taxes on saving and raising the expected return to capital should be adopted on its own merits. A byproduct of these changes would be a stronger economy and less dollar depreciation.
Congress is beginning to consider long- and short-term changes in the tax system. We have frequently urged Congress to free saving from taxation and permit firms to expense investment in new capital. These are attractive features of the bipartisan proposal introduced by Sen. Domenici and Sen. Nunn. We repeat our support for these reforms.
*Balanced budget amendment. A constitutional amendment to balance the federal budget has two main benefits. It forces Congress to pay for any new programs that it adopts. And it creates a public good. Each member of Congress agreed to reduce his demands for additional public spending in exchange for promises by other members to reduce their demands.
There are well-known disadvantages also. Congress would be encouraged to substitute regulation, state or local mandates, credit allocation, and other arrangements.
These indirect methods are often more costly and less desirable than the government spending they replace. A balanced budget would at times require higher taxes or reduced spending in recessions. It would permit unsustainable growth of government spending during expansions.
A balanced budget amendment directs too much attention to balance and too little to the level of spending and taxes at which the budget is balanced and the way in which resources are used.