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
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
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