Get smart about inflation.

For a moment this spring, madness was rampant. Whitewater crowded health care and education off the front pages; Barry Goldwater told the Republicans to get off Clinton's back; John Bobbitt announced he's marrying again. Most important, the Federal Reserve and Wall Street went bananas as rising interest rates sent the stock and bond markets on a roller coaster ride."Dow Falls 72 Points Amid Market Fears" screamed a March 30 headline in the Los Angeles Times. The subhead? "Seventh drop in eight days puts average 300 below where it stood two weeks ago. Investors are worried by interest rates and political turmoil."

This market madness is especially perplexing given the economic facts. Last winter, the economy finally hit its stride: Unemployment dropped; consumer confidence rose. Sales of automobiles, furniture, and other durable goods rose 15.4 percent, and new home sales jumped 31 percent. In fact, the economy overall grew at an amazing 7.5 percentage points in the last quarter of 1993, its strongest showing in over a decade. But in every silver cloud there is a dark lining. Consider this from The Washington Post's front page report on the growth figures: "[The 7.5 percent increase] cheered White House officials and economists but triggered a sell-off by Wall Street traders fearful that inflation is not far behind.... what they saw yesterday was more inflation, higher interest rates, and the end to the bull markets of the early 1990s."

What gives? Why, if things were going so well, did the financial markets immediately assume prosperity meant inflation? An assumption that we must break down--this is the reform--is that economic upswings are automatically followed by inflation unless the Fed raises interest rates to slow growth. If the country is to generate true, long-term growth, we must stop saying this, in the face of contradictory evidence, because the more we say it, the greater the chances the Fed and the markets will turn it into a self-fulfilling prophecy.

According to conventional wisdom, as the economy grows, people buy more goods. But when people buy more, we must produce more to fill their needs. Suddenly, there are production bottlenecks and labor shortages. This causes prices to rise. Wages then rise to keep pace with prices. The result: inflation. This view is so ingrained that few even question it; it is a staple of economic journalism, presented without question or nuance. On "Good Morning America" during the stock market's wild spring ride, for example, correspondent Stephen Aug said, "The trigger [for the stock plunge] was the news that the economy had created 456,000 new jobs during March. Traders felt that would lead to higher wages and higher prices."

To prevent this horror, the Federal Reserve has essentially one tool: its ability to affect interest rates. If the Fed pushes up interest rates, businesses and consumers will be less inclined to borrow money. If businesses don't borrow, they don't expand, and if individuals don't borrow, they can't spend as much. Thus, higher interest rates slow the economy and stifle inflation. Sure, a slower economy is bitter medicine. But, if it prevents inflation later--the traditional thinking goes--it's worth it. The Alice-in-Wonderland quality of all this can be summarized this way: As the economy recovers, the bond market gets anxious about inflation. So the Fed raises rates slightly in order to calm fears. Then the bond market takes that as confirmation that the Fed itself is worried about inflation, so it gets even more concerned.

But suppose an improving economy does not necessarily mean inflation is on the way? Suppose American producers can meet the demands of a growing economy? Suppose, in other words, that the chorus of voices in the economic community and the media that assumes that recovery equals inflation is wrong. If that were so, high interest rates would not be medicine but poison. After all, higher rates not only keep people out of work but can lead to a recession. And who benefits from those higher rates (aside from the bond sellers who make a tidy profit as the markets churn)? The well-to-do, especially those who can afford to keep a thick wad of cash in interest-earning money market accounts. David Shulman, Saloman Brothers, chief economist, admitted as much to the Post's Steven Pearlstein: "The economic recovery is now moving from Wall Street to Main Street," Shulman said early in March. "There will be less money flowing into the financial economy, and more flowing into the real economy."

In general, by raising short-term interest rates--as the Fed has done twice this year, on February 4 and again on March 23--the market makes bonds more attractive investments than stocks, drawing money away from companies that could use the money to expand. The better the rest of the economy, the more unhappy the bond market is, because people spend their money on investments other than bonds. (The reason both the stock and bond markets fell this spring had to do with speculators who were overextended and had to liquidate their securities when interest rates went up, thereby flooding the market with bonds and driving prices down. But the larger point remains: Had the conventional wisdom not put the rate rise in motion to begin with, the markets would not have fallen at all.)

Could it be that economic growth may not, in fact, lead to inflation and that the economic community's automatic assumptions are wrong? A look back at the periods of American economic growth shows that time and again the American economy can meet the demands of a revved economy. From 1954 to 1968, for example, the country had nearly full employment, strong growth, and virtually no inflation. (Unemployment in those years averaged 5 percent, which is even less than it is now, another sign that the conventional wisdom--high employment=higher prices--is wrong.) And before that, between 1800 and 1940, the economy also grew rapidly. Yet in 1940 the wholesale price level was the same as in 1800. In fact, the post-Civil War period until 1900 was a period of rapid expansion in real output accompanied by price deflation.

What makes the conventional wisdom seem especially nutty today is that the price of the on commodity that has been at the heart of the two most severe bouts of recent inflation--oil--is actually dropping right now. A proper understanding of history ought to show reporters and pundits that the inflation of the seventies had little to do with a growing economy or with an inability of American workers to meet increased demand, but instead was largely prompted by shortages, actual or imagined, due to the oil embargo. In fact, it's telling that the three periods of very high inflation since World War II--1946-47; 1973-74; and 1979-80--were all caused by real or imagined shortages of goods. (Laura Tyson, head of Clinton's Council of Economic Advisors, made this same point in The New York Times in mid-April.) With no such commodity problem on the horizon today, it's verging on insanity to stifle the recovery out of a baseless fear of inflation. Yet that is what is happening.

And where does that leave us today? Is inflation, in fact, on its way? Not if you look at the larger economic picture. For one, while the unemployment rate may be decreasing, there are still 8 million unemployed workers, 6 million involuntary part-time workers, and a relatively low factory utilization rate. The growth rate of the economy, according to the Fed, is projected to be 3.5 percent in 1994, hardly enough on its own to generate a surge in inflation. And there is plenty of drag on the economy from restructuring corporations, defense conversion, tighter government spending, and higher tax bills. Most important, prices of many commodities other than oil--such as coffee and cotton--are hovering near five-year lows.

Of course we need to be wary of inflation. But if we are to avoid an unnecessary recession, crazy market swings, and throwing people out of work, we--and this includes the media--must resist crying wolf about inflation every time unemployment drops. The Fed must not overreact to the bond market's anxieties, and Wall Street needs to understand that growth does not automatically mean inflation.