Top of the News: Commentary
GREENSPAN'S GRADUALISM AND OPENNESS ARE WORKING
Financial markets despise uncertainty. What other explanation is there for the behavior of bond prices, which slumped after the Federal Reserve nudged up short-term interest rates a quarter-point on Feb. 4, but rallied in response to an identical move on Mar. 22?
The latest action proved soothing because it was widely telegraphed by the Fed as part of an extraordinary effort to reveal its new monetary game plan. Such openness is a refreshing change that investors on Wall Street and consumers on Main Street alike should welcome.
The Fed's penchant for secrecy, under heavy attack in Congress, deserves much of the blame for the hysterical reaction by the stock and bond markets to the rate hike on Fed Friday. Even though Chairman Alan Greenspan broke precedent by announcing the February decision--his first tightening in five years--the news struck the markets like a lightning bolt.
NO CONFUSION. Traders assumed the worst, that the central bank saw signs of accelerating inflation and that the boost was the first of a string of swift rate increases. Over the subsequent month, yields on 30-year Treasuries jumped 70 basis points, nearly triple the Fed's increase in short-term rates (chart). "The market clearly overreacted," concedes Robert M. Giordano, an economist at Goldman, Sachs & Co.
By the time the policymaking Federal Open Market Committee met again in March, the markets were convinced that the federal funds rate, the interest charged on overnight interbank loans, would rise at least 25 basis points. Greenspan didn't disappoint. He even announced the move again, just to avoid confusion. The stock market yawned and bond prices rose. In all, long-term rates were up about 60 basis points since the February tightening, hitting 6.9 on Mar. 23. "Bonds rallied because the Fed underscored the Greenspan gradualism we have come to know and expect," says Lawrence N. Leuzzi, a managing director of S.G. Warburg & Co.
That's another way of saying that the markets think they've figured out what Greenspan is up to. And traders are convinced the outlook isn't so bad.
Above all, they no longer suspect that Greenspan is looking at some secret indicator of a worrisome rise in prices. The chairman's take on the economy is the same as that of most private economists: With worldwide demand weak, wages rising slowly, and productivity gains driving unit labor costs down, U.S. inflation is no problem today. But last fall's stunning 7.5% growth rate signaled that capacity and labor shortages could crop up soon. Although most economists expect growth this year to slow to around 3%, the Fed believes there's a good chance the economy will outperform that forecast.
Greenspan's fear, which markets now understand, is that if the Fed waits to see unmistakable signs of accelerating inflation, it already will be behind the curve. Then sharp rate hikes would be needed to damp inflationary fires. The Fed's bet: A little nip now will throttle inflation but not the expansion.
How high will short rates go? Greenspan has hinted he would like to see the spread between Fed funds and the inflation rate return to its historical level of 75 to 100 basis points. If inflation remains around 3%, that means rates might increase another 25 to 50 points this year. That would be in keeping with Greenspan's cautious style.
Finally, the markets welcome the new openness. The FOMC once kept its actions secret until six weeks after a meeting. The ostensible reason was to give the Fed chairman maximum flexibility in deciding when to raise rates and by how much. But the result was leaks and market turmoil as speculators bet on what the Fed was up to. Pressure from House Banking Committee Chairman Henry B. Gonzalez (D-Tex.) for prompt disclosure of FOMC actions is behind the Fed's sudden candor. But Greenspan also has found a virtue in political necessity: He is sending a clear signal to the markets and a strong message to the country that the Fed still considers inflation to be Public Enemy No.1. So look for openness to become a permanent feature. "This new style is a big improvement," says former Fed Vice-Chairman Manuel H. Johnson Jr.
The markets have given Greenspan a vote of confidence for his latest move, but he has yet to hear from the economy. As higher rates show up in mortgages and other loans, growth could weaken significantly. But as things look now, the Fed chairman may be able to achieve his goal of sustaining growth and inflation rates of about 3%
this year. If he does, no one will complain about Greenspan's Gradualism.Owen Ullmann