By Christopher Farrell There must be something about the Federal Reserve Board and two-word phrases that investors don't like. They reacted violently after the latest policymaking committee meeting when central bankers removed the phrase "considerable period" from their statement to the press about how long they intend to keep a neutral policy stance. Instead, they substituted a willingness to be "patient" about raising rates. The fallout reminded me of the anxiety attack investors had in December, 1996, when Fed Chairman Alan Greenspan uttered the two words that will be forever linked to his name, "irrational exuberance."
Why were investors so upset at the Fed this time? It effectively put investors on notice that it would eventually hike its benchmark interest rate. But come on now. Almost all Wall Street economists and money managers have been in agreement for weeks, if not months, that the central bank would tighten sometime in 2004, with a minority of those experts pegging the first few months of 2005 at the very latest. So, the only point worth debating was when, not if.
The reason for the market's reaction may be that the word change upset a cherished Wall Street assumption: That the Fed doesn't hike rates during the six months before a November Presidential election. The Fed's reluctance to start tightening monetary policy during the final months of a campaign for the nation's highest office is understandable. It doesn't want to give even the appearance of trying to manipulate the results.
FOLLOW THE LEADER. After all, some Republicans still blame Bush Sr.'s loss of the Oval Office on Greenspan for lowering rates too slowly back in 1992. Democrats are quick to point out that Greenspan has been friends with Vice-President Dick Cheney for decades. Still, the record reinforces conventional wisdom. The Fed has occasionally raised rates during election years, but it has never initiated a rate-hiking cycle, according to David Rosenberg, Chief North American economist for Merrill Lynch.
Yet things are different today. Financiers would send interest rates higher at the first suspicion inflation is about to revive. And nowadays the Fed follows the market rather than leads it. As James Carville, President Clinton's first campaign manager, put it: "I used to think if there was reincarnation I wanted to come back as the President or the Pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everyone."
Greenspan has far less room for maneuvering than did many of his predecessors, such as Arthur Burns, who spoke tough against inflation in the 1970s but ran a loose monetary policy. You can't fool today's tightly integrated capital markets, which feature linked satellite and fiber-optic communications networks spanning the globe.
SKEWING POLICY. That's in stark contrast to the past. And the Fed is an institution steeped in its own history, haunted by its failures and steeled by its successes. Among the central bank's worst moments in recent history was the chairmanship of Burns.
He was a leading scholar of the business cycle, and he sure looked the part of a central banker, always puffing away on his pipe. More important, Burns was a long-time adviser to Richard Nixon, who appointed him Fed Chairman in January, 1970.
Many veteran Fed watchers believe that Burns ran monetary policy with an eye toward helping Nixon get reelected in 1972. According to Bruce Bartlett, a senior fellow at the National Center for Policy Analysis, "to get Nixon reelected in 1972, Burns opened the monetary floodgates in an effort to stimulate the economy." William Greider, author of Secrets of the Temple, a history of the Fed, is unsure about the degree of connivance but argues that Burns consistently leaned monetary policy in a direction that would help Nixon.
SLAYING THE DRAGON. To this day, monetary policy scholars scorn Burns's performance. The inflation rate averaged above 7% in the 1970s, more than triple the average of the 1950s and 1960s -- and the Burns-dominated Fed shares much of the blame for the inflationary spiral. By the late '70s, prices were climbing at the pump, the supermarket, and the furniture store.
Government campaigns against inflation, such as Richard Nixon's wage and price controls and Gerald Ford's "Whip Inflation Now" buttons, had failed miserably. President Carter replaced Burns with the hapless G. William Miller, but inflation still appeared to be accelerating out of control. In 1979, Carter named Paul Volcker, an imposing, abrasive, 6'7" president of the Federal Reserve Bank of New York, to lead the Fed.
Volcker was an old-school central banker who believed his mandate was to slay the inflation dragon at all costs. He stomped on the monetary brakes. The economy dipped into two recessions. Millions of workers lost their jobs. But the process of containing inflation had begun.
OUT OF THE LOOP? Another inflation hawk, Alan Greenspan, followed the Volcker example, and today the Fed is considered one of the best-managed central banks in the world, with a wellspring of credibility. For good reason: America's consumer price index, a widely followed gauge of inflation, hovered at more than 14% in 1980. Today, it's around 1%.
Greenspan may be buddies with Cheney, but he answers to a higher authority today than the White House. And he's surely not about to put the Fed's hard-won reputation or his own renowned legacy at risk to endear himself with President Bush's cohorts. What's more, the Fed isn't under pressure to act any time soon. Core inflation remains at 1%, and the unemployment rate is 5.7%.
The hard truth is that global investors will let the Fed know when it's time to hike rates to lean against inflation. And the global bond market doesn't respect the U.S. election cycle. Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over Minnesota Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online