SYNOPSIS:

The Markets Are Running Scared. The financial markets always seem to be worried about something. For much of the past year, they fretted about recession. Now, as signs of recovery emerge, they are nervous about inflation. This new anxiety is reflected in the recent run-up of long-term interest rates, which have jumped from 8.2 percent to approximately 8.5 percent since early May. Long-term interest rates are surging even though the Federal Reserve Board recently cut short-term rates. The Fed was able to trim short-term borrowing costs by printing money and using it to purchase Treasury securities. Long-term rates, on the other hand, are less easily controlled because they depend on bond investors' expectations about the course of inflation.

The markets are probably right in turning their attention away from recession risks. Aside from the unemployment rate, which increased from 6.6 percent to 6.9 percent in April, almost every other indicator points to an economy that is on the mend. Consumer spending rose by 2.8 percent in April, for example, and retail sales were up 1 percent in May. But the fears about inflation are unfounded. Economic recovery usually does not lead to an immediate surge in prices; in fact, inflation traditionally falls for a year or two after a recession ends because it takes time for the unemployment rate to subside. Many economists believe that the inflation rate in 1992-93 will be lower than it was prior to the current recession.

There are three important rules to remember when thinking about inflation. The first, and perhaps most important, guideline is that monthly inflation numbers bounce around a lot and don't reveal very much. For example, Saddam Hussein's invasion of Kuwait last August drove up oil prices in the fall and led to several months of high inflation. During the third quarter of 1990, the consumer price index ran at an overheated 8.2 percent rate. Six months later, however, inflation was only a quarter as high. A sales-tax increase or a freeze that harms Florida's crops can cause a rapid spike in prices that will soon be forgotten.

High Unemployment Will Restrain Prices. The second rule is that changes in inflation depend on the level of unemployment. Inflation tends to rise when joblessness dips below 5.5 percent, and it falls when unemployment climbs above 6 percent. The double-digit unemployment rate during the recession of 1981-82, for example, led to a sharp drop in inflation. The consumer price index continued to decline as the economy began to rebound and the unemployment rate started to slide. Only near the end of the recovery, when joblessness dropped below 5.5 percent in the late 1980s, did inflation begin to creep up. The third rule to keep in mind is that it takes a big change in unemployment to really move the inflation rate. Generally speaking, a 1 percent rise in joblessness that is sustained over the course of a year will usually lower the inflation rate by just half a percentage point.

These three rules help put the current economic data in perspective. First, last week's inflation report is mostly noise and therefore should be ignored. Second, with the unemployment rate currently approaching 7 percent, an inflationary surge isn't likely; and the general direction of inflation will be down, not up. At the same time, there won't be a dramatic drop in inflation. Unemployment has not been high enough for long enough to lower the inflation rate by more than a fraction of 1 percent.

A Smooth Recovery. A reasonable forecast suggests that the American economy will emerge from the current recession with an underlying inflation rate of around 4 percent. That won't satisfy the economists who believe that the nation needs true price stability. But it means that inflation will be fairly passive and that the Fed won't have to tighten credit. As a result, the recovery won't be squelched. A year from now, the recession of 1990-91 may seem like a half-remembered bad dream.

New inflation jitters

The bond market, worried that economic recovery will stimulate inflation, has pushed up long-term interest rates.

30-year Treasury bond yields, daily closes

May

1 8.17 pct.

3 8.22 pct.

8 8.22 pct.

10 8.31 pct.

15 8.32 pct.

17 8.27 pct.

22 8.27 pct.

24 8.29 pct.

29 8.29 pct.

31 8.26 pct.

June

5 8.39 pct.

7 8.47 pct.

10 8.47 pct.

Growing rate gap

Long-term interest rates have remained high even though the Federal Reserve has cut short-term rates.

Long- and short-term Treasury yields

3-month 30-year

1990

J 7.74 pct. 8.45 pct.

F 7.77 pct. 8.53 pct.

M 7.80 pct. 8.62 pct.

A 7.91 pct. 8.99 pct.

M 7.76 pct. 8.57 pct.

J 7.74 pct. 8.40 pct.

J 7.49 pct. 8.41 pct.

A 7.37 pct. 8.98 pct.

S 7.13 pct. 8.94 pct.

O 7.12 pct. 8.77 pct.

N 7.03 pct. 8.39 pct.

D 6.52 pct. 8.23 pct.

1991

J 6.20 pct. 8.19 pct.

F 6.05 pct. 8.20 pct.

M 5.76 pct. 8.24 pct.

A 5.53 pct. 8.18 pct.

M 5.53 pct. 8.26 pct.

J 5.60 pct. 8.47 pct.

No price pressures

Inflation is not a threat in the early stages of recovery because of lingering joblessness.

Inflation rate, less food and energy, year over year

1980 12.4 pct.

1981 10.4 pct.

1982 7.4 pct.

1983 4.0 pct.

1984 5.0 pct.

1985 4.3 pct.

1986 4.0 pct.

1987 4.1 pct.

1988 4.4 pct.

1989 4.5 pct.

1990 5.0 pct.

1991 5.1 pct.

Originally published, 6.24.91