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Relax and Enjoy the "Greenspan Lag"

By Michael Englund With the cyclical turn in the labor market behind it, the next big milestone for bonds will be the shift in course for Federal Reserve policy. At MMS, we expect Chairman Alan Greenspan to reveal his historic tendency to take longer to initiate a round of interest-rate hikes than most monetary-policy hawks would like -- but to then raise rates more, and faster, than expected.

Greenspan waited until 1994 to start the tightening cycle after the 1990-91 recession. But he was able to launch it with a "surprise tightening," and then proceeded to raise rates so severely that the economy was nearly pushed into a premature recession. Similarly, the chairman has been blamed for fueling the global financial market bubbles with only one small tightening through the 1996-97 boom, bracketed by glowing assessments of the "New Economy," despite widespread calls for more significant rate hikes.

The ensuing four years were spent in mop-up operations around global financial market "bubble burstings" that might have been smaller had they been contained in advance.

APPEALING THEORY. As this economic recovery gains momentum, the Fed is committed to a highly accommodative monetary policy for a "considerable period," even though the risk of runaway economic growth that would be difficult to restrain is probably a much greater threat than the risk of deflation. Of course, this "Greenspan lag" may be viewed as the enlightened position that made the "New Economy" possible.

Indeed, to the extent that the Fed used low rates to help drive the investment boom associated with the transformation to an information economy, it can claim responsibility for pushing the U.S. economic growth rate to a higher path without necessarily prompting a greater rate of inflation. The theory is appealing, and the Greenspan lag may eventually prove to be the chairman's primary contribution to the more rigid monetarist policy approach put in place in the 1980s by then-Chairman Paul Volcker and his contemporaries abroad.

Greenspan has shown a tendency to ride out the "sweet spot" of a high-growth and low-inflation economy until the risk of inflation is imminent. His prior playbook includes progressively more pronounced references to low inflation and high productivity growth as the expansion matures, and a shift in preference to a more "neutral" policy stance only when the risks are so strongly biased toward higher inflation that even the chairman has to admit it.

SUMMER SCENARIO. Greenspan does like to surprise the markets at the turning points, which makes a strategy of riding out the sweet-spot tricky. But we think it's nowhere near the time for Fed rhetoric to presage the next policy tightening. We at MMS will stick with June, 2004, as our forecast for a first Fed funds-rate hike, and the chairman will likely stick with the most bullish verbiage he can get away with -- and do so right up to the point where he chooses to tighten.

The risk is that his words about the New Economy are just the new face on the old pattern of policy bumbling that Milton Friedman had so much fun attacking in the Fed of the 1960s and 1970s. That was before Greenspan's time, of course. And it's far too early to know yet whether the Fed chief is on target in his policy approach.

What we do know is that the last expansion was characterized by rapid growth in business investment and a sharp increase in production capacity. This may positively reflect the "excessive" monetary-policy accommodation in the late 1990s. And it's possible that the approach can explain the powerful acceleration the U.S. is enjoying in productivity. It's a big part of why the economy should continue to sharply outpace expectations.

Expect the debate to continue over the wisdom of Greenspan's once-tested approach. In the meantime, the Fed will find ways to keep the official policy statement more bullish than the market expects for a "considerable period." This is true even if the Fed feels that it has to replace this particular phrase in the next statement to maintain credibility. And despite recent criticism, credibility is one thing the Fed still has in its arsenal of policy weapons. Englund is chief economist for MMS International

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