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The Mostly Good News from Greenspan

By Michael Wallace When he reviewed monetary policy with Congress last July, Federal Reserve Chairman Alan Greenspan cautiously said he expected that the end of the war with Iraq would allow the economy to "gradually" emerge from underneath the shadow of war-related uncertainties.

More upbeat this go-round, Greenspan testified on Feb. 11 before the House Committee on Financial Services that the "picture has since brightened." Evidenced by vigorous economic growth, productivity gains, stable prices, and improving financial conditions, he said "impressive gains" had been made by both the consumer and business sectors of the U.S. economy. The only remaining caveats appeared to be the unusual lag in employment growth due to "stunning increases" in productivity and the cloudy fiscal situation.

In reviewing the improved tone over the past year, Greenspan noted the significance of federal tax cuts and rebates, robust household spending (thanks to lower interest and mortgage rates), and the attendant refinancing boom. Rising home and financial equity also helped bolster family balance sheets, while a surge in corporate profits helped unleash capital spending, particularly on equipment and software.

DEFICIT WARNINGS. Greenspan made a point of discussing the outlook for monetary policy in the context of the economy's transition to a more robust performance. Mirroring the Fed's statement released after a policy-making session in January, he warned that accommodative policy from the Fed would not be "compatible indefinitely with price stability and sustainable growth; the real federal funds rate [a key short-term rate the central bank controls] will eventually need to rise toward a more neutral level."

While this is yet more evidence that the Fed is poised to retrace some of its easing steps as early as this summer, Greenspan reiterated the Fed's "patience" in light of low inflation and lingering economic slack (see BW Online, 1/29/04, "A Big Jolt from the Fed's Small Switch").

He largely reiterated past warnings about rising budget deficits, which he said were due in part to the previous decline in equities, the past economic downturn, and fiscal stimulus aimed at combating those corrosive effects on growth. Conversely, he maintained that with the expansion well under way, tax revenues should rebound and help close the gap, which will nonetheless remain sizable.

DOLLAR REASSURANCE. Given the gloomy budget forecasts by the Congressional Budget Office and the Office of Management & Budget, and "since the ratio of workers to retirees will fall substantially" as the baby boom generation begins to retire, Greenspan remained leery of congressional inaction that would result in "more wrenching fiscal adjustments" ahead. In this regard, the main risk he spied is that increasing government borrowing to fund Social Security and retiree health care will crowd out the private sector and result in a large backup in long-term interest rates.

Despite House members' concerns about the falling dollar, Greenspan was not perturbed that Asian central banks could reverse recent large purchases of U.S. Treasuries. He said these were mostly of short-term maturities and unlikely to destabilize the capital markets, so long as any adjustment was gradual. Thus, he expected "no material adverse side effects," such as foreign investor flight or an inflationary spike from the dollar's recent declines.

However, Greenspan urged a prudent promotion of private and national savings via lower deficits in order to reduce risk of a seizure in foreign investment in the U.S. He also repeated his strident plea against creeping protectionism, which he warned should be reversed or else global economic growth might be put at risk.

HAPPY RESPONSE. In short, the chairman remained duly impressed by the U.S. economy's flexibility, and he sounded optimistic on the growth outlook, based upon relaxed credit conditions, inflation-adjusted short-term interest rates near zero, and a stimulative policy mix. He expects this potent combination to "spur the expansion of aggregate demand in 2004" even as a lid is kept on inflation.

How did investors react? With pleasure. Benchmark indexes rose smartly on his comments, and long-term interest rates fell. Wallace is Global Market Strategist for Action Economics, based in San Francisco

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