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April 22, 1994
"Clinton Still May Control Inflation"
San Jose Mercury News
By Timothy Taylor
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DURING 1993, the Clinton economic team enjoyed the pleasant task of watching interest rates drop. The interest rate on 30-year Treasury bonds, for example, fell from 7.34 percent in January 1993 to 5.94 percent in October.

The administration often loudly interpreted the lower interest rates as a sign that investors approved of Clintonomics, particularly the budget deficit reductions promised in Clinton's first budget. In the words of the February 1994 report of Clinton's Council of Economic Advisers:

"A sharp decline in long-term interest rates to 25-year lows, in large part the result of the administration's deficit reduction package, was the major economic story of 1993.... The Council of Economic Advisers expects long-term interest rates to remain relatively low for the foreseeable future..."

Frankly, it was never particularly plausible for the Clinton administration to claim full credit for the 1993 decline in interest rates. After all, the drop in 1993 simply continued an ongoing trend; the 30-year Treasury bond rate had already fallen from 9.03 percent in September 1990 to 7.34 percent in January 1993, when Clinton took office.

Even worse for the Clinton crew, this week's rise in interest rates has lifted interest rates to just above where they were when Clinton took office. After spending 1993 arguing that his administration deserved credit for inducing an economic recovery through lower interest rates, Clinton argued on Monday that the return to higher rates "should not do anything to harm the economy."

Whatever his problems with consistency, Clinton deserves credit for not raising a stink over the higher interest rates. He seems to realize that these higher rates are the financial markets' way of testing whether his administration is genuinely committed to low inflation.

Before anyone is willing to invest in a 30-year bond, or any other long- term investment, they must believe that the interest rate on that bond will both compensate them for future inflation, and provide an additional real return on top. Thus, long-term interest rates reflect beliefs about the future rate of inflation. For example, the belief that inflation was finally under control was a key factor pulling down long-term interest rates from 1990 through 1993.

Inflation is only about 2.5 percent at present, but there is some reason to be nervous that it might heat up. For starters, economic growth surged past 7 percent during the last quarter of 1993, firms are hiring again, and capacity utilization is high.

In response to fears that this rapid growth might pump up inflationary pressures, the Federal Reserve has hiked short-term interest rates three times this year -- on Feb. 4, March 22 and last Monday. The Fed proclaimed that these increases were only preventive.

But the interest rate increases were the first in five years. When an institution as authoritative as the Fed spots a threat of inflation lurking, the rest of the market finds it prudent to agree.

Clinton is in the spotlight because there are two vacancies on the Federal Reserve Board of Governors. The speculation is that he will appoint two economists to these slots: Janet Yellen of the University of California and Alan Blinder of Princeton University.

Both Yellen and Blinder are eminent academics, and from my occasional interactions with them, I can say that both are sharp, nice people. Both are usually regarded as "pragmatists," rather than hard-liners against inflation. The market may fear that their appointment signals that the Fed will be less committed to fighting inflation.

Of course, none of these factors prove that inflation is about to heat up.

But the financial markets are well aware that the last real surge of inflation began in the late 1970s under Jimmy Carter, the last previous Democratic president and another former governor inexperienced in monetary policy. Before that wave of inflation was brought under control, it drove the interest rate on 30-year Treasury bonds above 12 percent in 1981 and 1982.

For investors concerned with long-term interest rates, the memory of those days lives on.

The recent rise in interest rates has convulsed the stock and bond markets. This week's consensus seems to be that the Fed will push short-term rates still higher in the next month.

Clinton should just hold on through this short-run turmoil. If he supports the Fed's efforts to fight inflation -- by continuing to avoid criticism of the Fed, and by encouraging his new appointees to take the risk of inflation very seriously -- then the fear of renewed inflation should recede, and long- term interest rates will again decline.

If that happens, Clinton can legitimately claim that he faced a tough test from the world's financial markets, seasoned skeptics who doubted his commitment to stable prices, and that he did his part to keep the inflation genie all bottled up.

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