Can The Fed Hit Its Mark?

Greenspan has room to guide the economy to a soft landing

Bond traders have heartburn. Tech stocks remain breathtakingly volatile. And inflation-phobes are worked up over real and imagined price pressures. But in a spacious Washington office at the corner of 20th and C Streets, there's one remarkably serene person: Federal Reserve Chairman Alan Greenspan.

Although the economy continues to expand at a rapid clip, associates say that the Fed chief seems confident that the central bank's carefully calibrated policy mix and continuing productivity improvements have put the economy on the path to a soft landing--or at least a safe return to less scary growth rates.

For now, the signs of outright slowing in the U.S. economy are elusive, but they are there. The stock market has been essentially flat for half a year. Consumer confidence fell in October for the fourth straight month. Housing starts declined in September to their lowest level since June, and sales of existing homes fell 2%. Durable goods orders for everything from washing machines to computers dropped in September for the first time in five months.

STAGNANT MARKET. The Fed has done its part. With its two quarter-point rate bumps in June and August, the central bank has guided long-term interest rates to levels not seen in two years: 30-year Treasury bonds are yielding 6.4%, up from 4.7% a year ago, and 30-year mortgages are now above 8%. In response to the tighter money and periodic Greenspan hectorings, the stock market--one of the main drivers of the economy over the last few years--has stalled. Ultimately, the stagnant market should rob the economy of some of its strength next year by sapping consumer and corporate confidence. "We are likely to see a slowing in the economy in the year 2000," San Francisco Fed President Robert T. Parry predicted on Oct. 26.

Slowing, not screeching to a halt. That's the scenario that Greenspan wants to play out. And, with inflation still at bay, there is no reason for the Fed to administer bitter monetary medicine. That doesn't rule out a third rate hike on Nov. 16, but that could be the last for a while.

But what about all those scary signs that economists saw just a few weeks ago--a soaring Producer Price Index, rising energy prices, and tight labor markets? Some of the data was skewed by one-time events such as a jump in tobacco prices. More important, with some exceptions, companies continue to match cost increases with productivity improvements. The evidence: a surge in third-quarter profits that shows companies can still rack up earnings by boosting efficiency when they can't raise prices. Instead of petering out, as Greenspan once feared, "Productivity has been accelerating," Chicago Fed President Michael H. Moskow noted on Oct. 25.

That means the economy's speed limit, just publicly raised by Greenspan to about 3% annually, could go higher into uncharted territory. "If productivity growth were to continue to increase," Moskow muses, "economic growth could be sustained at even higher rates."

Further proof that the productivity payoff can keep inflation quiescent and growth surging came on Oct. 28, with the Commerce Dept.'s announcement of sweeping revisions of past Gross Domestic Product statistics. The report, which recalculates GDP from 1959 to 1998, raises the annual economic growth trend line by as much as 0.4% in recent years.

The bottom line? Key Fed policymakers feel that rates are now close to the desired level required to underpin a more sustainable expansion.

To be sure, not everyone at the Fed is as relaxed as the chairman seems to be. Some hawkish Fed policymakers doubt that the long-awaited slowdown is finally at hand. They see annualized growth topping 4% in the fourth quarter after a heady run earlier in the year. They're also skeptical that productivity can power ahead at ever faster rates and worry that wage pressure and rising commodity costs could ignite inflation next year. Their concerns would gain greater credence with evidence of wage-driven inflation such as a big rise in the Employment Cost Index.

For now, Greenspan appears to be convinced that his patented blend of incrementalism has put the economy on the glide path to slower growth. Still, steering the U.S. economy is always tricky. Greenspan knows that well from his experience in 1994 and 1995, when he hit the brakes to bring growth down to sustainable rates. The Fed wound up doubling short-term interest rates in the space of a year. That produced more of a "touch-and-go" landing. The economy quickly regained altitude in '96 and then soared, having unloaded its inflationary baggage, thanks to the Fed's tightening. This time, Greenspan can anticipate a smoother ride, given that the fundamentals are much better than they were five years ago.

Content as he may be, Greenspan can ill afford to wait for inflation to show up before he pounces. But that traditional preemptive approach is more difficult in an economy where growth and inflation no longer seem to be riding in tandem. "If policymakers react early and quickly, they can alter inflation expectations and cut off the rise in inflation," says the San Francisco Fed's Parry. "But when there's a high degree of uncertainty about the underlying structure of the economy, it could be best for policy to tend more to the cautious part of the spectrum."

WILD CARD. Among the uncertainties complicating the Fed's task: the nascent economic rebound overseas and volatile financial markets. If growth abroad picks up strongly, that should boost demand for U.S. exports and make the Fed's task of slowing the U.S. economy more difficult. However, the European Central Bank is likely to raise rates Nov. 4 amid signs that Europe's economy is picking up steam.

Wall Street is an even bigger wild card. If share prices suddenly surge, capital and consumer spending are likely to follow. Of course, if the markets crash, that could throw the economy into a recession, despite the Fed's best efforts.

So will it be a soft landing? Despite the deft economic management to date, remember to keep your seatbelts securely fastened until the economy taxis safely to the gate.

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