When Federal Reserve Chairman Alan Greenspan kicked off his credit-tightening campaign on June 30, there was no question why he was raising interest rates. Inflation was picking up, and the recovery appeared to be on solid ground: Gross domestic product had grown at a 5.3% annual rate over the previous three quarters, and even the sluggish jobs market had finally sprung to life.
Now, though, the case for tightening isn't as obvious. Despite a 40% leap in oil prices since late last year, inflation has ebbed. Meanwhile, the jobs market has softened. While the 144,000 rise in August payrolls was double the dismal 73,000 increase in July, it was well below the heady 295,000 monthly pace of the spring. That has led some at the Fed to wonder whether they should pause before moving ahead with further hikes.
But despite the uneasiness of some of his colleagues, Greenspan left little doubt in congressional testimony on Sept. 8 that he's intent on raising rates when the Fed meets two weeks later. While taking comfort in the recent dip in inflation, Greenspan believes price pressures will pick up eventually if the Fed keeps rates low for too long. Something that bears watching: Labor costs -- considered by Greenspan to be a key factor behind inflation -- have turned up.
At the same time, the Fed chief is convinced that the recent slowdown will be short-lived and that the economy is strong enough to take another quarter-point hike. Indeed, Greenspan told Congress that "the expansion has regained some traction." He cited a July pickup in consumer spending and housing starts and continued solid business investment.
What's more, Greenspan seems unsure whether job growth has been as subdued as the latest payroll numbers suggest. A separate government survey of employers used to measure job openings did not show the same degree of weakness as payroll numbers did. According to that survey, private-sector job openings jumped markedly in July.
While Greenspan welcomed the recent decline in inflation, it did not come as a surprise. Throughout the spring, as criticism of the Fed's lax monetary policy mounted, he argued that the rise in inflation was likely to prove "transient." And so it has. After climbing sharply last year, commodity prices have leveled off in recent months as supply has started to catch up with global demand. Even oil prices have come off their peaks, though Greenspan conceded on Sept. 8 that the outlook is uncertain. More important, there's little sign that higher oil prices are seeping into the rest of the economy. Excluding energy, consumer prices rose just 2.1% in the year through July.
What Greenspan is focused on is the long-run outlook. And on that score, there's reason for caution. Productivity growth is slowing from its recent super-strong levels. Coupled with rising wages and health-care costs, that's pushing up Corporate America's outlays for labor. After falling steadily over the past two years, unit labor costs at nonfinancial companies have grown in 2004, rising at an annual 2.6% pace in the second quarter.
The Fed is hypersensitive to even small signs of wage inflation because interest rates are so low. Despite two Fed rate hikes this year, the federal funds rate -- the rate commercial banks charge each other for overnight money -- stands at a mere 1.5%. That's far below the 4% or so that some Fed officials reckon is the equilibrium rate for the economy. And as long as rates are below that level, Fed officials believe monetary policy is acting to stimulate growth and push up inflation.
Through one of the most perplexing recoveries in memory, Greenspan has steered a consistent course. He ignored the pleas of inflation hawks for bigger rate hikes when prices spiked in the spring, and now he's playing down worries of the doves as growth slows. He figures a slow-but-steady flow of rate hikes will avoid surprising the markets -- and be best for the economy in the end.
By Rich Miller in Washington, with Peter Coy in New York