It's a new world out there, and the old economic models don't seem to work anymore. Nowhere is the change more apparent than at the Federal Reserve. After years of debate, Fed Chairman Alan Greenspan has convinced his fellow governors that fundamental changes in the economy--especially the shift toward low inflation--require change in monetary policy. Gone will be the old, secretive Fed, which held that the economy is inherently unstable and requires preemptive action to avoid trouble (especially inflation). In its stead is a new, more transparent central bank that works by telegraphing its concerns and intentions to the markets. By simply making known its bias toward easing or tightening, the Fed will rely on stock and bond markets to do their own economic fine-tuning. But when the financial system is really threatened, as it was last fall when Russia defaulted, the Fed will still come in with direct decisive action.
The Greenspan approach is good news for these changing times. Old economic models tell us that the economy should be slowing this late in the business cycle. Instead, domestic demand is rising. Inflation should be surging. It is falling. Productivity should be plummeting. Yet it, too, is rising. Key concepts, such as NAIRU, the nonaccelerating-inflation rate of unemployment, and the Phillips Curve, have lost their ability to explain and predict.
To his credit, Greenspan recognized early that there is a new economy even if he could not define all of its contours. Conservatives on the Fed still wanted to rein it in. Greenspan was willing to test its limits. When traditional forecasts predicted higher inflation, he held off those who wanted to raise interest rates, betting that productivity and globalization would hold prices in check. They did.
His opponents are becoming converts. Now, the Fed will be less inclined to intervene preemptively, more open about its opinions, and more likely to give growth the benefit of the doubt. This is a policy shift of historic dimensions.