INFLATION REALITY

INFLATION REALITY

he Federal Reserve is now confronted with rising inflation, not merely the threat of inflation. Costs for medical care, rent and transportation, for example, have begun accelerating. The surge in oil prices helped to push the consumer price index up to an annualized rate of 4.1 percent in the first quarter. The employment cost index rose a sharper-than-expected 1.4 percent in January-March, putting this measure up 4.3 percent from a year earlier.

The time has come for Fed Chairman Alan Greenspan to abandon his favored policy of gradualism and support a half-point increase in the federal funds rate when the Federal Open Market Committee meets on May 16.The Fed has raised its key funds rate target five times in quarter-point increments to its current level of 6 percent. To date, it has had little effect on slowing the economy, which has been zipping along at an average growth rate of 6 percent for the last three quarters.

The real risk is that the Fed is falling behind inflation. If it doesn't act resolutely, it could endanger its credibility, economists say. As the Fed's stated task is to prevent inflation, it needs to regain control of the situation.

Judging by recent comments, Fed policy-makers appear to be preparing the markets for more-aggressive Fed tightening. Robert McTeer, president of the Federal Reserve Bank of Dallas, who is generally considered to be one of the most dovish of Fed officials, has shifted the tone of his comments recently. He noted that inflation was surrendering last year, but this year it is resisting arrest.

With strong economic data and possibly no opposition, the Fed most likely will have to push the funds rate up to at least 7 percent this year, economists forecast. The money markets, which had anticipated two more quarter-point moves this year, are now expecting four more quarter-point moves. If that doesn't slow the economy, there could be additional moves next year.

Fed officials were understandably reluctant to raise rates aggressively before actual signs of inflation appeared. After all, traditional full-employment models failed to take into account the technology-induced surge in productivity.

As evidence of actual inflation begins to pile up, however, stronger action is called for. Economists said that the expectations of the market have shifted to such a degree that the Fed might appear timid if it moves only 25 basis points.

Even the housing market, supposedly one of the more interest-rate-sensitive sectors of the economy, remains robust. Sales of new homes rose 4.5 percent in March and have remained vigorous despite the rise in interest rates over the past year and a half. Some buyers have shifted to adjustable-rate mortgages, economists said, while others have found housing still affordable because of strong income growth or gains in equity portfolios.

With more households owning homes than stocks, and with home values still moving higher, a ''wealth effect'' remains firmly in place, despite recent volatility in the stock market, economists said.

Chairman Greenspan's preferred inflation index, the personal consumption deflator, rose 3.2 percent in the first quarter, up from 2.5 percent in the fourth quarter of 1999. Many economists predict that an extremely tight labor market and the federal government's added demand for workers to conduct the census will contribute to still-higher core prices in coming months.

The clear signs of rising inflation pressures mean the Fed must shift from being preemptive to being reactive. Real money market rates have not kept pace with the increase in inflation. The real federal funds rate (adjusted for inflation) is 2.3 percent, which is below its historical average and far from being restrictive.

Economists also point out that the federal government's decision to pay down the debt as much as possible with its budget surpluses has lowered longer-term interest rates and freed savings to finance the private sector. This is dampening the effect of a restrictive monetary policy and could mean that the Fed will have to raise short-term rates higher than it expected before they have sufficient bite.

Bank credit growth and the money supply are rising rapidly, indicating that there is too much liquidity in the system. Unless the Fed acts quickly to offset it, this extra liquidity is going to debase the currency, and we will all be poorer for it. Recent developments make it very difficult for the Fed to stay the gradualist course.