Fed's young strategy for fighting inflation won't be shelved now

MICHAEL KERAN thinks he knows how the Federal Reserve System is today managing the nation's crucial monetary policy. If Mr. Keran, the chief economist at Prudential Insurance, is right and the policy continues, the United States should not be having double-digit inflation soon. Keran was until two years ago chief economist at the Federal Reserve Bank of San Francisco. In that position, he sat through years of meetings of the Fed's policymaking Federal Open Market Committee (FOMC). But Keran didn't hear anyone announce at those closed meetings the monetary policy rule he believes is now dominant. It may not even be an entirely conscious policy change. After all, the FOMC is made up of 19 independent-minded Fed officials, 12 of whom are voting at any meeting. They each have their own method for figuring whether credit should be tightened, loosened, or kept steady.

Nonetheless, he observes that the ``revealed preference'' of the Fed is to target nominal growth in the gross national product, that is, the output of goods and services in current dollars.

This is a fundamental change in the Fed's monetary strategy, Keran says. It ``may have increased the frequency of business cycle slowdowns, but more significantly has decreased their severity.''

In the past, the primary focus of the Fed's monetary strategy was to maximize the growth in real GNP (after inflation) over the business cycle. The Fed would maintain an easy monetary policy to keep the economy rolling at a good speed until the inflation rate exceeded a politically tolerable level. Because of the long lag between easy money and much higher inflation, that process might take three to five years.

Then the Fed would slam on the brakes to slow inflation. This tight-money policy would last until the political squeals resulting from a higher unemployment rate became too loud. Since tight money quickly prompts higher unemployment, the slowdown or recession might last a year or less.

This system, says Keran, worked well in the 1950s and '60s in keeping inflation low and unemployment under 7 percent of the labor force. But the strategy broke down in the 1970s and early '80s. Both the inflation and unemployment rates soared above 10 percent on two occasions. Possibly this was caused by the boost in oil prices by the Organization of Petroleum Exporting Countries, combined with a tendency for greater synchronization of the business cycle among industrial nations.

Whatever the causes, after May 1983 the focus of monetary strategy under chairman Paul Volcker has been to prevent inflation from ever reaching politically unacceptable levels, not simply to react to inflation after it occurs.

At a meeting of the FOMC that month, the Fed nudged monetary policy modestly toward restraint, even though the unemployment rate remained above 9 percent. Nor, recalls Keran, was there a near-term risk of reaccelerating inflation. And the nation was barely six months beyond the trough of the worst recession in more than 40 years.

Under this inflation-preventing strategy, the Fed allows monetary policy to be easy until nominal GNP growth exceeds some target level. That is now about a 7.5 percent annual growth rate, Keran figures. When this occurs, the Fed tightens up until nominal GNP growth falls below about 6.5 percent. Then it loosens up again.

Since the lag between changes in monetary policy and its effect on GNP is relatively short, about six months, the new strategy produces more frequent periods of tight monetary policy and subsequently frequent periods of below normal growth in GNP.

But Keran sees the policy as a success. The strategy has prevented inflation from soaring, enabled the Fed to avoid Draconian tightening of monetary policy, and reduced the risk of severe business slumps. Inflation has stayed in the 3 to 5 percent range; unemployment has gradually declined. The stock and bond markets have thrived.

Keran believes the new chairman of the Fed, Alan Greenspan, will continue this strategy when he takes over as chairman next month. The Fed's professional staff will train him in its advantages.

But if he fails to accept this policy, the bond market will bring him back to the straight and narrow. Whenever GNP growth accelerates sharply, those active in the bond market recall their dramatic losses from high inflation and low bond prices in the early 1980s. They start selling, pushing prices down and long-term interest rates up - trends that snap the Fed to attention.

Indeed, another economist observer of this phenomenon, Dr. Edward Yardeni of Prudential-Bache, speaks of the ``bond vigilantes.''

Bond prices fell when first-quarter GNP numbers were announced in April. The first estimate of GNP for the second quarter was announced Friday. It showed output growing at a 2.6 percent annual rate.

That was slower than the first quarter but faster than the bond vigilantes had expected. It seemed likely to buoy the bond market.