THE CURRENT recession looks like an unusually short one -- a piece of good luck that promises to increase the conflict over economic policy. The recession is not yet over, and unemployment is very likely to rise further in the months ahead. But auto sales and housing starts have both risen from their very low levels of last spring. The indications of improvement are convincing.
That's good. But it also gives greater urgency to all of the hard questions about managing the recovery. A longer and deeper recession would at least have brought the inflation rate down further. In the aftermath of the last recession, inflation was down under 5 percent a year. Over the coming year, in contrast, it seems unlikely to fall much below 10 percent. What kind of policy can push the recovery forward without generating higher inflation than ever?
There's conflict between what might be called the Washington and New York perspectives. Washington and the political world tend to focus, in a recession, on the present moment and the unemployment rate. New York and its financial world are already fixed on next year and its inflation rate. Reacting to the signals of an early end to the recession, the bankers and brokers there are already beginning to show renewed anxiety over inflation. That's why interest rates have been moving upward for the past couple of weeks.
The percent lift in interest rates is a very peculiar departure from previous patterns. But it's not irrational, nor should it be unexpected. The rules of the game have changed.
In past recessions, interest rates have declined steadily until well after the turnaround. As business activity fell, fewer people borrowed money. As the demand for money fell, the price of money -- the interest rates -- fell with it. But this summer, the lenders, foreseeing an early return to growth and to inflation, are pushing up their rates to protect themselves.
In the past, the Federal Reserve Board could respond to a recession by increasing the money supply. That kept interest rates low, encouraging the recovery. It worked so well that the Federal Reserve generally succumbed to the temptation to overdo it.
This year, it seems to be working just the opposite way. At any hint of accelerated expansion of the money supply, the financial world would immediately assume that the government was embarking on another big inflationary binge. Regardless of the demand for loans, the interest rates would start to climb -- as they did, dramatically, earlier this year.
In the past, presidents and Congresses have leaned heavily on the Federal Reserve to cooperate in anti-recession strategy, and pump out money faster. But this year, the Federal Reserve is caught between Washington and New York. Meanwhile, the forecasts of a short recession also indicate a very slow recovery from it.The lesson seems to be that, in a period of high inflation, government policy rapidly loses its flexibility.