The Future of the Fed

Alan Greenspan has guided the U.S. through boom and bust. A new debate over policy is just beginning

Is the glass half full or half empty? The last couple of years have been tough for the U.S. economy and for Federal Reserve Chairman Alan Greenspan. A shallow recession has been followed by a recovery that still shows few signs of taking off. Greenspan has sounded oddly uncertain about the economy's direction: "This is one of the most difficult periods of forecasting we have confronted," he told economists in London on Sept. 25.

That's a sobering admission from a man who became a national icon in the 1990s. In his 15 years as head of the Fed, Greenspan has presided over a period of strong growth, low inflation, and low unemployment (charts, page 96). And he has managed numerous crises--from the stock market crash of 1987 to the terrorist attacks of 2001--remarkably well.

Beyond that, Greenspan became the quintessential New Economist, the man who correctly foresaw that information technology was spurring faster productivity growth, enabling the U.S. economy to grow more rapidly without inflation than anyone had thought possible. It was Greenspan who gave the economy room to run when the conventional wisdom dictated tightening to ward off inflation that never came. The result was the sort of prosperity not seen for a generation--strong business investment, higher wages, and a soaring stock market--benefiting millions of Americans. Even after the sharp sell-off on Wall Street, stock prices as measured by the Standard & Poor's 500-stock index are twice as high today as they were when the boom started in early 1995. And the productivity revolution that Greenspan correctly heralded continues even in the current sluggishness, much to the surprise of most economists.

But if Greenspan deserves credit for the productivity-driven boom, he is also vulnerable to criticism for the bust that took place on his watch, particularly in the tech and telecom sectors. The NASDAQ index is down 71% from its high in March, 2000, and the dot-com era is remembered mostly for its excess and folly. Deflation is a threat for the first time in 70 years, and the labor market can't muster a sustained recovery. Many fear that Greenspan may be running out of policy options to deal with today's problems. Even the Nov. 6 rate cut--which took short-term rates down to 1.25%, the lowest since 1961--may not be enough to repair the damage wrought by the bursting of the stock market bubble and the uncertainty engendered by the threat of terrorism and a potential war with Iraq. "We're fighting some pretty powerful forces," one Fed official says.

At stake here is more than just academic arguments over Greenspan's legacy. What matters most is the future of Federal Reserve policy.

Why? Because Greenspan, in formulating his strategy, developed an approach to monetary policy based on the observation that the economy is always evolving in response to changes in technology, regulation, and other factors. That means monetary guidelines that are useful at one moment may need replacing. Greenspan is convinced that the Fed has learned to identify quickly changes in the way the economy works by monitoring a wide array of published data and real-time information--and by modifying its forecasting models accordingly. The result is a monetary policy that changes as the economy's structure changes.

If Greenspan is right, this approach represents an enormous advance in central banking, which historically has been based on either fixed rules or seat-of-the-pants policymaking. It would also be a major step forward compared with traditional economic forecasting models, which have often missed big shifts in the economy.

In particular, the way we think about asset markets may need to change. Greenspan believes the stock bubble may be a side effect of a successful monetary policy. That is, when the central bank can stamp out inflation and reduce the risk of recession, it encourages investors to take more chances with their money. This can lead to boom-bust cycles in asset markets--but it may also mean more capital spending and innovation and bigger productivity gains. Financial volatility may go along with good policy and strong long-term growth, just as athletes are more prone than couch potatoes to suffer certain types of injuries.

Whether or not Greenspan is right in the long run, the economy's recent troubles are strengthening the hand of critics who would change the Fed's direction after his departure--likely in 2004. While the Fed leader is still widely admired within the bank, his colleagues seem less willing to defer to his judgment than when he was at the height of his intellectual influence in the late '90s. At the Fed's Sept. 24 meeting to set rates, two policymakers openly broke with Greenspan's decision to hold policy steady, the first time in four years that there has been such dissent. Publicly, there's also far more discussion of the possibility that monetary policy during the boom ended up worsening the bust.

As the excesses of the 1990s become clearer, support for Greenspan's flexible brand of New Economy monetary policy is weakening among bank policymakers and leading outside economists. Rather than being held up as a model for future generations of central bankers, Greenspan may be viewed less favorably. Thus the next Fed chairman may be less willing to adapt to a changing economy than Greenspan was--and less willing to emphasize growth.

That's likely to mean a central bank that is quicker to raise interest rates once the economy picks up steam, more hesitant to risk letting unemployment decline as low as the 3.9% it reached under Greenspan, and less inclined to have the U.S. economy serve as the engine of global growth.

Two different visions of the post-Greenspan Fed are emerging: the "inflation-targeting" school, led by new Fed Governor Ben S. Bernanke, an economist from Princeton University, and the "anti-bubble" school, advocated by Stephen P. Cecchetti, former research director of the Federal Reserve Bank of New York and now an Ohio State University economist.

Supporters of "inflation targeting," who also include another former New York Fed research director, Frederic S. Mishkin of Columbia University, agree that Greenspan has been a great central banker. But they think the Fed's main aim should be to control inflation. Some worry that Greenspan creates confusion when he testifies to Congress about the importance of growth and productivity. "Inflation--it's the one thing they can control, and should control," says Robert E. Lucas Jr., a Nobel prize-winning University of Chicago economist. In this view, the Fed should just stick to its knitting.

The inflation targeters want the next Fed chairman to set a target range for inflation publicly and then regularly report to Congress on how well the Fed has met that goal. The advantage of inflation targeting is that it reduces uncertainty. Consumers and businesses would know that if inflation rose above a set level--say, 2%--the central bank would act to cool off growth. The inflation targets would also ensure that the Fed would boost the economy if inflation fell too low and became deflation, which is today's main worry.

Other influential voices are arguing that the Fed needs new monetary-policy rules--not only for inflation but also to moderate financial-market excesses. The "anti-bubble" economists, including Cecchetti and longtime Wall Street guru Henry Kaufman, say that Greenspan got it wrong in the '90s by allowing the stock bubble to distort the economy. Among the first to warn of the dangers of the market bubble was Lawrence B. Lindsey, now President George W. Bush's economic adviser. In the fall of 1996, Lindsey, then a member of the Fed's board, called behind the scenes for higher rates to control the "irrational exuberance" that Greenspan would warn about just two months later. In the end, however, Lindsey deferred to the chairman and voted to hold rates steady. In retrospect, former associates say, he believes the Fed should have raised rates modestly. "The Fed should have done more to prevent the financial-asset bubble," agrees William C. Dudley, chief economist at Goldman, Sachs & Co.

A key member of this school is Andrew Crockett, general manager of the Bank for International Settlements, the central bankers' club in Basel, Switzerland. He argues that financial bubbles can lead to economic instability, with hard-to-control deflationary consequences. Hard-core anti-bubble types want the next chairman to act against excesses in all asset markets, such as an unwarranted run-up in stock prices, a housing bubble, or even an overvalued currency.

The future of the Fed will largely depend on who is chosen as the next Fed chairman. Greenspan's fourth four-year term ends just months before the Presidential election in 2004. While some speculate that Greenspan might stay on beyond that date to avoid enmeshing the appointment of his successor in election-year politics, he is clearly nearing the end of his career. So far, no obvious successor has emerged. The early favorite, monetary economist John B. Taylor, has not impressed the financial markets with his performance as Treasury Under Secretary for International Affairs. Bush adviser Lindsey has lost favor in his struggle to manage the President's fractious economic team. And with Wall Street hit by scandals, the financial sector is not likely to produce a credible candidate any time soon.

If the economy weakens, President Bush might lean toward appointing a Fed chairman who would give growth a boost. Such a move would be especially tempting if Greenspan stepped down before the 2004 elections. That would argue for someone like Dallas Fed President Robert D. McTeer, a strong proponent of the productivity-driven New Economy. The White House has not yet shown its hand by word or deed. Bush's appointments to the Fed board so far have been strong centrists, and Greenspan is known to be delighted that the President has shied away from using his appointments to the Fed for political purposes.

Nevertheless, both the inflation targeters and the anti-bubble economists have been actively proselytizing. Since his appointment as Fed Governor in August, Bernanke has informally talked to a number of the members of the Fed's main policy arm, the Open Market Committee, about the need to set public inflation targets.

Greenspan and his supporters in the bank, including William J. McDonough, head of the New York Fed, Roger W. Ferguson, vice-chairman of the Fed, and Donald L. Kohn, a new appointment to the Fed board, staunchly defend the chairman's brand of central banking. While the Fed watches prices very closely, Greenspan has resisted explicit inflation targeting because he believes that the changing nature of the economy makes it hard to pin down exactly what inflation goal is appropriate. Worse, formal inflation targeting risks tying the hands of the Fed chairman in the event of unexpected shocks. "If we have something like September 11 happen again, I sure wouldn't want to be caught having to think about a price-stability target when the main thing you're trying to do is restore public confidence," one policymaker says. After the terrorist strikes, the Fed flooded the financial system with funds, providing much-needed liquidity.

And Greenspan has been unwilling to commit the Fed to using monetary policy to intervene in asset markets, even those that seem wildly out of whack. In an August speech at a Federal Reserve conference in Jackson Hole, Wyo., Greenspan argued that "it was far from obvious that bubbles, even if identified early, could be preempted short of the central bank inducing a substantial contraction in economic activity--the very outcome we would be seeking to avoid."

Greenspan is also undoubtedly mindful of the historical record, which shows that the Fed has courted disaster when it has tried to broaden its mandate to include the stock market. In the late 1920s, Board Governor Adolph Miller led a concerted campaign to rein in high-flying stock prices. The eventual result was that the Fed tightened monetary policy in 1928 and 1929, even though inflation was nil. The perverse move helped trigger the stock market crash of October, 1929. Moreover, the Fed did not move aggressively enough to cut rates after the crash, setting the stage for the decade-long Great Depression.

Faced with an investment boom and a stock market bubble reminiscent of the 1920s, Greenspan followed a different strategy. He elected instead to ride the runup in the stock market, believing this would be better in the long run than prematurely pricking the bubble by jacking up interest rates. Once the bubble burst, however, he acted swiftly to limit the impact on the real economy, cutting interest rates 11 times in 2001 in the fastest credit-easing campaign in the Fed's history.

Bernanke shares Greenspan's reluctance to restrain rapidly rising asset markets. Even such stock market bears as Robert J. Shiller, the Yale University economist who has consistently argued that stocks are overvalued, agree with Greenspan and Bernanke that raising rates in the 1990s could have proved disastrous. "If they had raised interest rates to burst the bubble," says Shiller, "they could have tanked the economy."

Still, Shiller and other economists believe that the Fed had ways of acting against the stock mania, short of raising rates. For example, increasing the cost of buying stocks on credit by lifting margin requirements would have helped, posits Shiller, although only a limited number of investors would have been affected. "Like putting warning labels on liquor bottles," says Shiller, it would have been a signal from the Fed to investors that they should be more wary. Alice M. Rivlin, a Brookings Institution economist who was vice-chair of the Fed from 1996 to 1999, agrees. "The one thing I regret is that I didn't push harder for raising margin requirements," she says.

Former Fed Governor Janet L. Yellen points out that Greenspan could have used his influence to get that point across as well. After he was attacked for warning of the dangers of irrational exuberance in 1996, he mostly stayed away from the topic. "I wish he had continued to talk about it," says Yellen. For his part, Greenspan doubts public jawboning is useful unless it's backed up by higher interest rates.

Privately, associates say that Greenspan's objection to reining in the runaway stock market was political as well as economic. He thought the central bank lacked the mandate to act, and he worried that raising rates to restrain the bubble could have caused a political backlash that compromised the Fed's cherished independence.

History, however, shows that the Fed's mandate evolves over time. For example, the emphasis on inflation fighting--which today is integral to the Fed's mission--didn't take hold until soaring prices and a falling dollar forced President Jimmy Carter to appoint Paul A. Volcker as Fed chairman in 1979.

Similarly, the events of recent years are pushing Greenspan to take more account of financial markets. He realizes that as wealth rises faster than income--as it has over the past 20 years--the asset side of the nation's balance sheet becomes more important.

The wild card in the debate over the future of the Fed, of course, is what happens in the next couple of years. If the U.S. economy and stock market bounce back quickly, Greenspan and his forward-looking approach will look a lot better. If today's slump continues, the next Fed chairman will be tempted to do something rather different.

There's a third possibility: If the economy stalls and fears of deflation increase, the Fed will feel pressed to rev up short-term growth by any means available. The danger: If prices and incomes start falling, the financial system could seize up. Borrowers would find it harder to pay back debts, and banks would be unwilling to lend money at near-zero interest rates. Moreover, the Fed's usual policy tools for boosting growth would become less effective. Typically, the Fed combats recessions by trying to create so-called negative real interest rates--rates below the level of inflation--to induce skittish consumers and companies to borrow and spend more. But if inflation is negative, that strategy won't work, and the economy could fall into a downward spiral.

The prospect of deflation has already altered the attitudes of anti-inflation hawks such as Richmond (Va.) Federal Reserve President J. Alfred Broaddus. "I've spent most of my career focused on reducing inflation," he said in a speech earlier this year. "[But now] I've become more conscious of the kinds of policy problems that can arise in a low-inflation, low-interest-rate environment, especially when the economy softens."

Still, Fed policymakers are confident--cautiously so--that the U.S. can avoid the fate of Japan, which seems stuck in a deflationary trap. Greenspan, for one, believes that a lot of Japan's problems are cultural and structural. In a society that prizes consensus, Japanese authorities have not taken the tough steps needed to overhaul the country's banking sector.

Moreover, should deflation hit and U.S. short-term interest rates fall to near zero, Greenspan and other members of the Fed have said that they are ready to take unconventional policy measures. "There's a general view that as the federal funds rate gets to zero, we are out of business," Greenspan told the Council on Foreign Relations on November 19. "That is not the case." Among the potential strategies: buying long-term bonds to drive long-term interest rates down and purchasing foreign currencies to lower the dollar's value. In theory, such measures could stimulate growth: For example, a lower dollar should boost exports. But in practice, the Fed has far less control over long-term interest and exchange rates than it does over short-term interest rates.

Another concern, both inside and outside the Fed, is the value of the dollar. Some Fed officials suspect the dollar is overvalued: They liken it to the pre-crash stock market. They worry that the dollar-driven trade deficit is unsustainable in the long run and will eventually lead to a disruptive plunge in the dollar. But Greenspan and his supporters don't see what they can do about the dollar's value, short of driving the economy into recession and drastically reducing America's demand for imports. So they've adopted the same approach that they used for stocks: Wait--and be prepared to act quickly to limit economic fallout should the dollar suddenly collapse.

In the end, Greenspan's legacy will be judged by how the economy does in the next couple of years. A weak performance will tarnish the gains of the 1990s and cause people to back away from Greenspan's strategy of a flexible monetary policy and his espousal of a high-growth, high-risk economy. But if growth picks up and the stock market recovers, which many economists expect, then Greenspan's vision of the future will prevail--and the chairman would go down in history as the best central banker ever.

By Rich Miller

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