(FORTUNE Magazine) – FOR MORE THAN A YEAR the Federal Reserve has been tightening the money supply, and short-term interest rates now are some 2 1/2 percentage points higher. The payoff may be coming, judging by such signs of slower economic growth as lagging industrial production and retail sales. But what if the Fed has been too rigorous, and the next recession is beginning to take shape? Must the U.S. murder its longest peacetime expansion in order to choke off inflation? So far the Fed gets high marks for cutting down the oxygen without killing the patient. But inflationary pressures are building from growing wage demands at home and rising prices abroad. FORTUNE expects that inflation in the U.S. will reach a persistent 5.5% rate next year. That's far too high for comfort: If the Fed loosens its grip, the rate could go higher still. Some notable economists think all this nail biting is not necessary. Yes, they say, we should resist rising prices, but not with recession's brutal bludgeon. The cost to the nation is too high, the production that is lost through layoffs is gone forever, and there are less stinging ways to control rising prices. Ranged against these doves are such hawks as W. Lee Hoskins, president of the Cleveland Federal Reserve Bank, who argues that we should give no quarter in the war against inflation. The eventual goal, he says, should be none -- zero, zip, nada -- whatever the costs may be. FORTUNE flies toward the hawkish end of the formation. By its nature inflation breeds the expectation that prices will rise even faster. Therefore, the least painful course over the long term is to dampen that expectation, even at the risk of a downturn. But recession is a blunt and mean instrument, and should it seriously threaten the economy, Congress will likely listen < sympathetically to the doves and lean heavily on the Fed to reverse policy. If Congress bullied the Fed successfully, that would invite further inflation -- and an even more painful correction eventually. Recession exacts a punishing tax. By rule of thumb, unemployment would have to rise a percentage point from recent levels -- that is, 1.2 million more people out of work -- and stay there for a full year to knock just half a point off the inflation rate. The price tag: some 2% to 2.5% less GNP growth. Princeton economist Alan S. Blinder calculates that the total levy on the nation from excess unemployment between 1974 and 1986 -- much of it attributable to recessions -- was a stunning $1.9 trillion in 1986 dollars. Add to this the penalty paid by investors in lower share values and lost dividends and the hardship meted out to the poor and near poor who lose their jobs. Blinder blames the recessions of 1980 and 1982 for raising the proportion of people living below the official poverty line from 11.7% in 1979 to more than 15% in 1983 and for contributing to the widening disparity of incomes in the 1980s. WHAT A GRISLY TOLL, say the doves, who count Blinder among them. How extravagant a price to pay for what may be only a temporary reprieve from inflation -- or worse, a misguided effort to solve a problem that doesn't exist. Because it's not clear that today's unemployment is low enough to push inflation higher. The rate that would do that is known in economese as Nairu, for non- accelerating inflation rate of unemployment. When inflation began to speed up last year, most economists thought Nairu was around 6% or even 7%. They figured Blinder had gone soft in the head when he declared in 1987 that the rate was probably below 6%. But Blinder was right. Today, by most estimates, Nairu is between 5% and 6%. Now imagine what price the U.S. might have paid if, following the conventional wisdom, a ham-fisted Fed had put the economy through a wringer in 1987 to head off inflation when unemployment dropped toward 6%. What happened to confound yesterday's estimates? Two structural changes in the economy of the 1980s -- the decline of unions and the growth of international competition -- broke the easy postwar patterns in which big industries like steel and autos caved in to labor and passed the increased costs on to a captive marketplace. When labor markets tighten today, wages and prices do not go up in knee-jerk fashion. Says Nobel laureate James Tobin of Yale: ''It seemed improbable 15 years ago that there would ever be such concessions and actual rollbacks in wages and benefits.'' In comparison with the dramatic penalties of recession, the costs of inflation are hard to pin down. Supposedly it is the ''cruelest tax,'' victimizing most poignantly the elderly and others on fixed incomes. It plays havoc with financial planning and investment decisions and shifts wealth arbitrarily among groups. Shareholders and debtors gain, while bondholders and creditors lose. But doves such as Blinder argue that there aren't so many old folks on fixed incomes nowadays because Social Security payments are indexed. And variable-rate loans mean fewer gains for debtors at the expense of creditors. All serious economists agree that a country has to counter inflationary surges by reining in demand. Where the doves peel off from the consensus is in their belief that anticipated inflation, the kind that reflects price expectations built up over time, is not much of a problem. When prices rise steadily and predictably, they say, wages, pensions, loans, and other contracts adjust. In today's deregulated financial markets, for example, interest rates are more likely either to incorporate the anticipated rate as an inflation premium over the real rate or to float up and down with changes. That's true not only for corporate and government borrowing but even for the spending money consumers keep in interest-bearing checking accounts. The trouble is, expectations change. A year ago inflation was 4%; this year it's closer to 5%. Those rates of inflation do creep up. If the nation decides 5% is acceptable but the political cost of maintaining it starts to rise, well, who's to say that 6% might not be acceptable -- and 7% and so on? Too many people gain from inflation, not least the government's big spenders, who get more money without having to ask the voters for it. Yes, the doves do raise legitimate challenges to assumptions about the costs of steady inflation that hawks accept as holy writ. But the doves' arguments are not persuasive. While workers who are well organized or in tight labor markets may get their raises, the poor and the near poor have no such bargaining power. Their meager earnings may catch up to the rate of inflation eventually, but a couple of years of lagging behind can be rough when the prices of rental apartments and second-hand cars are rising. Inflation raises ; the cost of financial transactions and distorts investment patterns. A rate higher than those of major trading partners lowers living standards to the extent that it depresses the dollar. Financial markets will exact stiffer interest payments. A tax code that ignores inflation creates more inequities. For example, the interest earnings that lenders get incorporate an inflation premium to cover the loss of principal, but all the earnings are taxed. Take a bondholder in the 28% bracket earning a nominal 9% on a Treasury bill when inflation is running at a steady 5%. Her effective interest is 4%, but she's taxed on the whole 9%, a 63% rate on the actual return. Inflation gets clearly more painful when the rate accelerates. The higher and more volatile the rate, the more arbitrary the redistribution of wealth and the more time and energy everybody spends trying to outsmart the price spiral instead of producing useful goods and services. If foreign investors conclude that U.S. inflation is heading notably higher, their flight from the dollar could provoke the recession everyone wants to avoid. RISING PRICES have to be resisted, but how? The job should be relatively simple today, when the inflation pressure is coming from an economy bumping up against its productive limits. The federal budget is a powerful tool for managing demand, and cutting it would cool the fevers. Though higher-than- anticipated tax revenues have shrunk the deficit 17.9% so far this fiscal year, Washington is dragging its feet on serious cost cutting. As a result, economists are talking again about some long-discredited alternatives. That perennial favorite, wage and price controls, has failed every time and everywhere it has been tried, but visionaries keep dreaming up new approaches anyway. James K. Galbraith, an economist at the University of Texas and son of the eminent John Kenneth Galbraith, recently proposed an elaborate scheme that would synchronize all wage bargaining and peg cost-of-living adjustments not to past price increases but to a projection by the President for the coming year. Alas, there's no chance of getting labor and management to agree to such a system -- even if it would work. An older notion, the tax-based income policy, or TIP, would be easier to superimpose on the present system. It would use the tax code to penalize companies and employees for raises in excess of the inflation rate -- or reward them if they settled for less. But if Americans didn't tip their hat to TIP when inflation hit double digits, there is less reason for them to do so now. Tobin, who urged an incomes policy in the late 1970s, has laid aside the quest, though he argues that the government should post guidelines and jawbone employers. A generalized threat by the Fed to crack down when inflation heats up is no threat at all, he argues, because people will keep struggling to improve their relative wages -- cops will want more than firemen, Harvard professors more than their Yale colleagues. But who would heed the guidelines, either? INDEXING remains popular with the if-you-can't-lick-'em-join-'em crowd. Blinder, for example, thinks it could solve the problem of the tax code's distortions. The capital gains schedule might incorporate a table of inflation factors to calculate increases for stocks or bonds bought in the past and sold during the tax year. The figuring could get complicated, he allows, but ''it would be trivially simple compared to filling out a passive loss deduction form, which many of us have to do now.'' But what kind of signal does indexing send? Economists Lawrence Summers of Harvard and Stanley Fischer argue that it may be useful if people do not expect prices to rise much anyway. Otherwise, it confirms suspicions that the government is not serious about fighting inflation. Like it or not, a stern central bank, its gimlet eye fixed disapprovingly on the punch bowl, is the best line of defense. Because inflation in the short run usually means more growth and only minor price increases, elected officials are constantly tempted to tolerate it. It's no coincidence, Summers says, that countries whose central banks are highly independent of other government policymakers do best at containing inflation (see table). Though the Fed's policies have raised short-term interest rates over the past year, long-term rates have held steady, implying that the financial markets don't expect the inflation rate to rise. Confirmation comes from the most recent survey of institutional investors by Drexel Burnham Lambert's chief economist, Richard B. Hoey. They anticipate a rate of about 4.7% over the next decade -- practically the lowest rate they've foreseen since Hoey began surveying in 1978. In congressional testimony last spring, Alan Greenspan said his long-term goal is a rate of inflation ''approximating zero,'' implying that anything much higher will sooner or later fail the expectations test. Cleveland's Hoskins, one of the Federal Reserve Board's superhawks, has a detailed plan for reaching zero. But his Godzilla gambit implies regular bouts of recession -- or the risk of them -- and seems no more politically viable than an incomes policy.

THE FED, he says, should declare that it is committed to reducing inflation gradually over the next three to five years until the average annual rate is zero. It should spell out its plan by setting an upper limit on a broad price measure like the CPI, and then knock that limit down by a percentage point a year. After any month in which the CPI rose above the prevailing cap, the Fed's goal -- or in Hoskins's take-no-prisoners words, its ''single, dominant, all-inclusive objective, without regard to any other objective of policy'' -- would be to bring the CPI under its limit again, even at the cost of inducing a recession. Most economists suspect that zero inflation is not a practical target, if only for technical reasons. Poor measurements of productivity in service industries, for example, tend to overstate inflation by understating actual output gains. In the end even Hoskins hedges slightly by defining zero as less than 1% a year. The principle of reducing inflation to the lowest technically feasible rate leaves room for some disagreement about the actual level. During the 1950s most economists accepted the prevailing 1.5% as equivalent to zero inflation. The West Germans become anxious at 1% or less, the Swiss at 2%, and the Japanese at 2.5%. The main point is that keeping inflation stable at any rate means convincing people that there will be no acceleration. The faster prices rise, the harder it is for a government or central bank to remain credible. Americans fear inflation deeply because they understand that small doses make life easier for more people than care to admit it. Like the vices of prim Victorians, the enjoyment of inflation is best practiced on the sly if it's indulged in at all. Letting it into the parlor raises the terrifying prospect that it will race out of control, like so many other vices. As First Boston economist Albert M. Wojnilower puts it, ''We've delegated the conscience that governs us, but it remains our own.''

CHART: NOT AVAILABLE CREDIT: NO CREDIT CAPTION: THE PAINFUL TRADE-OFF Recession is a harsh antidote -- but it works. Unemployment has to rise one point for a year to knock half a point off the inflation rate.

CHART: NOT AVAILABLE CREDIT: SOURCE: NBER MACROECONOMICS ANNUAL, 1988 CAPTION: HEADING IT OFF The scale runs from 0, totally beholden to politicians, to 4. Where the central bank is strong, citizens expect less inflation.