The Fed experiments

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When Dr Alan Greenspan was appointed as chairman of the Federal Reserve in 1987, there were doubts in the financial markets about his suitability for the role. Many thought he had been chosen mainly because of his links with the Republican Party and were concerned that the Fed would lose the independence from the White House developed in the era of Paul Volcker.

In the event, however, Dr Greenspan has proved an extremely adroit central banker. The Fed has, in fact, received far too little credit for its handling of monetary policy in an exceptionally difficult environment in the past few years.

Faced with a massively over-leveraged economy, and a banking sector riddled with bad debts, the decision to ease monetary policy progressively from early 1991 onwards may seem in retrospect to have been an obvious one. But, compared with other central banks in similar positions around the world, the Fed moved early and in sensible steps.

If it had not done so, the world might easily have suffered a slump to rival that of the 1930s in terms of severity. So we have much to thank Dr Greenspan for.

He now has another difficult issue on his plate. For many years the Fed has hinted that it would respond to a significant cut in the government's budget deficit by reducing American interest rates.

This has been the carrot Fed chairmen have consistently dangled in front of the administration to encourage political boldness on the budget.

Obviously, with Congress now dithering over President Clinton's budget proposals, Dr Greenspan knows that any move towards higher interest rates would be politically inopportune, to say the least. Yet there have been signs of rising inflation pressure in the US, and a good central banker might want to move early to nip these in the bud.

The annualised rate of consumer price inflation so far this year has been running at about 4.5 per cent, excluding food and energy, compared with 3 per cent last year. But there have been special factors at work - severe winter weather, inadequacies in seasonal adjustment and large one-off rises in basic commodity prices such as lumber.

Furthermore, inflation pressures in the labour market remain extremely subdued, with unit labour costs increasing at under 1 per cent a year.

So why the concern? The problem, if there is one, stems from capacity utilisation in the manufacturing sector, which has remained higher during the recent recession than in earlier downturns. After the latest data revisions, capacity utilisation is now estimated to be running at 81.4 per cent, just below the level of 82-83 per cent at which inflation has usually picked up in the past.

The US economy is therefore conducting an interesting experiment. There could quite soon be some genuine upward pressure on manufactured goods prices, triggered by a lack of physical capacity in American companies. However, there are no signs of any rise in labour cost inflation, and conventional estimates of the 'output gap' in the whole economy suggest that GDP is about 3 per cent below potential.

It follows that the excess capacity in the economy must be almost entirely in the service sector, where inflation pressures should continue to subside.

Faced with these conflicting pressures, it would be surprising if inflation in the economy as a whole were to rise very much in the near future. In fact, as the special factors which have distorted the inflation rate upwards during the first quarter of the year begin to abate, inflation should drop back to around 3 per cent. (As they say in America, there is neither inflation nor deflation - just flation.) This being the case, any tightening by the Fed in the remainder of this year should prove very modest, if it occurs at all.

The outcome is being very carefully watched by the Bank of England, since a similar mix of conditions applies in the UK. In the second of its Inflation Reports, published last week, the Bank says that the output gap in the economy should be wide enough to keep inflation down for some time, though it admits that measuring the gap is subject to great uncertainty.

The graph shows two measures of the gap developed at Goldman Sachs. The first simply assumes that the capacity of the economy has continued to grow at its trend rate of 2 per cent per annum since the end of 1990, when output was last at its trend level. Given the decline in actual GDP that has occurred since then, this produces an estimate of the output gap equal to 6 per cent.

Capacity erosion

But this estimate makes no allowance for the possible erosion of economic capacity that has occurred during the recession. We can use information on capacity utilisation in the CBI survey, and other evidence from the labour market, to derive a very approximate estimate of how much erosion in capacity may have taken place.

When we do this, we find that the output gap may be no larger than 2-3 per cent, which would be eliminated by a couple of years of output growth averaging just 3 per cent per annum.

This large element of uncertainty about the size of the output gap leaves the Bank equally uncertain about the outlook for inflation in 1994 and beyond. Their best guess is that core inflation, before allowing for the impact of tax changes on the RPI, may be running at about 3 per cent next year, slightly below this year's likely rate.

But the combined impact of VAT on fuel bills and the council tax will be to add about 0.8 per cent to prices next year. On the Bank's calculations this will leave the Government's target variable - retail price inflation excluding the mortgage rate - running at about 3.8 per cent in 1994.

However, the Bank admits that the inflation rate next year could be anywhere between 1 and 7 per cent, depending on how wide the output gap turns out to be, how fast it narrows from now on and what effect this has on inflation.

No economic forecaster can say with any precision how these factors will pan out. But most careful models of the inflation process suggest that labour cost inflation will remain very subdued throughout the next two years, and that this will place continuing downward pressure on service price inflation.

Meanwhile, there could be some increase in price inflation for manufactured products as the effects of the devaluation, and of a tightening in capacity utilisation, come through.

The net effect of these changes is only likely to keep inflation hovering inside the top end of its 1-4 per cent target band provided sterling remains close to its recent levels - which is why the Bank seems so pleased that the currency has appreciated in the past few weeks.

Assuming that the exchange rate remains around its present level of 81 on the sterling index, the Bank seems likely to favour leaving base rates unchanged.

But if sterling should depreciate even a little - say back to its February low point of about 77 - the logic of the Bank's argument should force it to favour a tightening in monetary policy. This is the nature of the straitjacket in which the authorities have voluntarily placed themselves by setting a specific 1-4 per cent target for inflation - something which Dr Greenspan would never make the mistake of doing in America.

(Graph omitted)