Trying To Halt Inflation's Charge

By Barbara Rudolph

When Alan Greenspan became chairman of the Federal Reserve Board a year ago, no one expected him to behave like a blindly loyal servant of the Republican Party. But some skeptics feared that his long-standing ties to the G.O.P. would make him loath to hurt Republican chances during a presidential campaign by raising interest rates, even if such a move seemed necessary.

Last week Greenspan proved those critics dead wrong. In an effort to keep inflation at bay, the Fed raised its discount rate from 6% to 6.5%. That bellwether interest rate, which the central bank charges on loans to financial institutions, now stands at its highest level in two years. Says Robert Hormats, vice chairman of the Goldman Sachs International investment house: "The increase, announced just a week before the Republican Convention, puts to rest any doubt about Greenspan's independence."

Major banks followed the Fed's lead. By week's end the prime lending rate for business borrowers rose from 9.5% to 10%, a three-year high. The rate hike was poison for the stock market: the Dow Jones industrial average fell 73.26 points in two days after the central bank announcement and closed on Friday at 2037.52, down 81.61 for the week.

The Fed Chairman and his five fellow board members boosted the discount rate because they feared that the economy might be overheated enough to speed up the pace of inflation. The Fed became particularly concerned a week and a half ago, when a new employment report was released. While it showed that the unemployment rate climbed from 5.3% to 5.4% during July, largely because of a surge in the number of teenagers entering the work force, the figures also indicated that the economy had created 283,000 jobs in the month, a sign of strong growth. One other worrisome sign appeared last week, when the Government reported that wholesale prices rose at an annual rate of 5.7% in July, up from a 2.2% rise in 1987.

Many economists share the Fed's view that inflationary pressures are building. Paul Getman, director of financial services at the WEFA Group, an economic-consulting firm based in Bala-Cynwyd, Pa., predicts that within the next six months consumer prices will rise by as much as a 6% annual rate, compared with last year's 4.4%. But others voice concern that the hike in the discount rate could damage the economy. Democratic Senator James Sasser of Tennessee is concerned that higher interest rates could strengthen the dollar and widen the trade deficit. A rising dollar tends to make U.S. exports less attractive to overseas consumers at the same time that imports become less expensive for American buyers.

The jump in the discount rate did give a short-term boost to the dollar. In one day, the value of the greenback jumped from 1.90 West German marks to 1.92, its highest level in 18 months. But by week's end foreign-exchange traders sold dollars and drove the value of the currency back down. They calculated that U.S. trading partners might intervene to prevent the U.S. currency from rising too far.

The Fed apparently decided to boost the discount rate now because board members know that it is best to cool an economy in the early stages of overheating. If growth gets out of hand and inflation soars, drastic measures -- sudden and steep jumps in interest rates -- might be needed to get prices under control. Greenspan and his colleagues want to avoid that at all costs.

With reporting by Richard Hornik/Washington and Wayne Svoboda/New York