Greenspan Inaction Also Hazardous : Another Fed Rate Increase May Backfire, Experts Say

WASHINGTON —  Federal Reserve Chairman Alan S. Greenspan, considered by many analysts to be partly responsible for this week’s panic on Wall Street, now faces the uncomfortable prospect that almost anything he does could backfire.

“Greenspan is now where no Fed chairman wants to be--chasing the markets rather than leading them,” said John Makin, senior economist at the American Enterprise Institute. “Unfortunately, the markets are calling the tune rather than the Fed.”

Behind the plunge in the financial markets is a sharp increase in interest rates, surging upward out of fear that long-dormant inflation is returning. And Greenspan, who has been in office only about two months, may paradoxically have added fuel to the inflation fire by declaring early this week that the price outlook did not alarm him.

Greenspan’s comments alarmed investors, who feared that he would not be as vigilant as his predecessor, Paul A. Volcker, in guarding against rising prices.

So now the mere prospect of inflation--whether justified or not--is propelling the markets downward. Greenspan and the six other Fed governors may find themselves forced to quell the fears by increasing the Fed’s key discount rate by as much as a full percentage point above the current 6% level.

The hope is that such a move would convince investors that the Fed will stop at nothing to keep inflation under control.

But the danger is that the Fed’s action might push rates so high that they would undermine the nation’s five-year-old economic expansion--depressing the stock market still further.

‘Fed is Really Caught’

“The Fed is really caught right now,” said economist David Wyss of Data Resources Inc., in Lexington, Mass. “They are in a position where almost anything they do is going to have bad impacts.”

How did Greenspan get into this predicament? It began, ironically, with mounting evidence this summer that the U.S. economy was growing stronger as unemployment dipped below 6% and demand for a wide variety of industrial commodities soared.

Those signs of economic health also pointed to a possible round of rising prices. So Greenspan, in an early display of his determination to fight inflation and thus support the international value of the dollar, tightened monetary policy in early September during his first weeks at the Fed’s helm.

That had the effect of boosting short-term interest rates, which in turn had a dampening effect on stock prices.

Reluctant to Boost Rates

Reluctant to continue the round of interest rate increases, Greenspan declared early this week that rates had gone up enough and that the price outlook did not alarm him. And that, analysts say, was a mistake.

“By saying there is no danger of inflation, Greenspan is playing into the fears of the markets,” said Irwin L. Kellner, chief economist at Manufacturers Hanover Bank in New York. “What concerned investors about Greenspan is that as the Republican choice for Fed chairman, he would be tempted to keep the economy going at all costs as we move into an election year. He has to prove himself.”

With investors already nervous, the rout on Wall Street was touched off when the Commerce Department reported Wednesday that August’s trade deficit failed to shrink as much as expected.

Fear of Falling Dollar

Investors began to fear that the dollar, which has been relatively stable since February, would fall again in foreign currency markets. That would aggravate inflation by boosting the cost of imports, which now account for more than 20% of the goods Americans buy.

“Right now the markets are focusing on the dollar and trade,” said DRI’s Wyss. “It took only a small disappointment on trade this week to cause a collapse. The markets were really just looking for an excuse to sell.”

Adding to Greenspan’s predicament is the growing interdependence of global financial markets, which makes it increasingly difficult for the United States to conduct economic policy without regard to what other major nations are doing.

“The joker in the deck is the dollar,” said Stephen H. Axilrod, vice chairman at Nikko Securities in New York and the former chief staff member at the Fed. “If the dollar drops sharply, the Fed will have to move quickly to establish credibility.”

Bonds Siphon Stock Market

That would mean higher interest rates, which increase the attractiveness of dollar-denominated securities to foreign investors. But higher rates on fixed-rate bonds also lure money out of the stock market.

The dollar itself so far has remained relatively steady against other currencies, but Treasury Secretary James A. Baker III raised doubts this week about the Reagan Administration’s determination to defend the currency when he suggested that the dollar might have to fall because of West Germany’s recent interest rate increase. While Baker tried to confine his anger to Germany, there is the danger that a general fall in the dollar could cause cash-rich Japanese investors to pull back from the U.S. market.

“It used to be that ‘Made in Japan’ was a label you found on a stereo, but now it applies in part to U.S. monetary policy,” said Donald Straszheim, Merrill Lynch’s chief economist. “Bond yields in Japan have been rising, but we need that Japanese money to finance our deficits. So rates have to go up here to keep attracting Japanese money. You have to recognize that what’s going on is not entirely Greenspan’s fault.”

That may not prove much comfort to Greenspan.

Greenspan’s Early Test

“He is being tested a lot earlier than people expected,” said Kathleen Cooper, chief economist at Security Pacific National Bank in Los Angeles.

John O. Wilson, chief economist at Bank of America in San Francisco, added: “The Fed under Greenspan does not have the same flexibility or time to deal with economic problems as Volcker did.”

Next Tuesday, the Fed chairman is scheduled to deliver his first major speech when he appears before the American Bankers Assn. in Dallas. But the markets are more likely to react to what the Fed does in the days and weeks ahead than to what Greenspan says.

“It may be a cliche,” Axilrod said, “but action speaks louder than words.”