SYNOPSIS: When the Fed matters and when it doesn't is hard to tell

When I was around 8 years old, I had an occasional playmate who was incapable of having a simple good time. If he was having fun, he would overdo it, getting more and more wound up -- until, inevitably, he would burst into tears and throw a tantrum.

Maybe he grew up to become a market analyst.

By rights, last week's half-point increase in interest rates should have been a non-event. A rational financial market supposedly reacts only to news -- and last week's move, which had been all but pre-announced by Fed officials and which newsletters had been predicting for a month, came as no surprise to anyone. And indeed on the day of the increase, markets took it calmly. But then the commentary began to take its toll: Inflation is back, we're headed for a hard landing, there's a 50-50 chance of recession. To listen to some of what's being said you would imagine either that Alan Greenspan had suddenly revealed himself as a financial sadist or that the mighty U.S. economy had suddenly been revealed to have feet of clay.

So maybe it's time to re-establish some perspective.

The real news -- the background to the rate hike -- came not last week but over the couple of months previous, as it gradually became obvious that the U.S. economy had finally reached the limits of its much-expanded ability to produce. Everybody who wasn't living in a complete fantasy world knew this was going to happen eventually; the amazing thing is that it took so long. And the signs that we have reached our limits, though clear enough, are also fairly subtle: a modest increase in inflation, mainly due to oil but with some uptick in the "core" rate that supposedly excludes transitory factors, an acceleration of wage increases to a rate a bit more than productivity growth. Clearly it's time for the Fed to tap the brakes, to reduce the growth of demand enough to bring it into line with the growth in supply. But what now passes for a slowdown -- reducing growth to, say, 3 percent for a while until the inflationary pressure eases -- would have looked like a boom only a few years ago.

Could we be talking about something much worse than that sort of benign slowdown? Bad things do happen when the Fed is in inflation-fighting mode: the monetary contraction that began in 1979 eventually drove the unemployment rate into double digits. But back then the Fed was dealing with an economy in which inflation had been out of control for years, long enough that expectations of continuing inflation were deeply embedded in the national psyche; the Fed needed to take drastic measures in order to restore price stability. Those drastic measures, and the bad times they caused, wouldn't have happened if the Fed had moved quickly to control inflation before it had time to get established -- if, in other words, the Fed of the 70's had done what Mr. Greenspan is doing now.

True, there are other dangers. Attempts to nip inflation in the bud sometimes lead to the unpleasant discovery that your financial system is weaker than you thought, with nasty consequences for the real economy. That's what happened to Japan a decade ago, and it still hasn't recovered (and won't, if Mr. Greenspan's counterpart at the Bank of Japan -- who apparently is a financial sadist -- follows through on his plan to raise interest rates despite falling prices). But recent events in the U.S. actually suggest that we aren't as vulnerable as some, myself included, have feared. After all, the Nasdaq -- which is where the irrationally exuberant presumably put their money -- has fallen by more than a third, yet stories of sudden bankruptcy, of failed investors jumping from windows or shooting up brokers' offices, have been reassuringly scarce. In a way the bad news -- or rather the financial system's ability to take it in stride -- has been good news: I at least am becoming steadily less worried about a Japanese-style implosion.

This does not abridge the right of investors to bear qualms. If you think that stock prices in general are still too high -- a defensible position, though not quite as compelling now that some of the air has gone out of the tech bubble -- go ahead and sell. But don't blame the Fed.

Originally published in The New York Times, 5.24.00