After being revered for years as a monetary maestro, Federal Reserve Chairman Alan Greenspan now finds himself the subject of derision and doubt. Stung by wild swings in bond prices, investors blame the Fed chief for misleading the markets about the threat of deflation and the central bank's likely response to it. The result has been a loss of Fed credibility. And that's making it hard for the central bank to convince investors that the improving economy won't bring tighter credit and faster inflation.
In an effort to set things straight, Greenspan used the Kansas City Fed's annual end-of-summer meeting of monetary mavens in Jackson Hole, Wyo., to provide his first public exposition of his brand of monetary policy. Unfortunately, his explanation fell short, raising as many questions as it answered. It also sowed confusion about one of the prime topics preoccupying the bond market: Just when will the Fed start raising rates?
Greenspan dubbed his strategy a "risk-management approach" that involves weighing the probabilities of various economic outcomes and acting accordingly. He tries to minimize the risk of particularly damaging developments, such as deflation, even if he thinks such dangers are not likely to occur. "Such a cost-benefit analysis is an ongoing part of monetary policy decision-making," he said.
That's the approach the Fed followed when Russia defaulted on its debt in 1998. Although the Fed believed the U.S. economy would weather that crisis, it cut interest rates anyway in case it was wrong.
The Fed chief's remarks, which had little impact on the market, went straight to the heart of an age-old debate in monetary policy. Should central bankers set interest rates using strict policy rules, such as those that link rate changes to the ups and downs of inflation and unemployment? Or should they use discretion?
Not surprisingly, Greenspan favors more flexibility. And on its face, the strategy makes sense. Monetary policy "is like driving to Jackson Hole," says economist Michael Mussa. "You want to follow the road, but if you meet a herd of bison on the way, you stop."
But in practice, carrying out such a flexible policy is difficult. Greenspan says a risk-management strategy is necessary because the economic and financial outlook is fraught with uncertainty. Trouble is, if the Fed doesn't clearly explain how it sees the risks, its own policy response can add to markets' uncertainty. That's what happened lately as investors have struggled to figure out just how far the Fed would go to minimize the remote risk of a deflationary downturn.
Nor do the markets have a clear sense of what the risk-driven strategy means for rates in the coming months. If the Fed cut rates so sharply in part because of deflationary risks, what will it do now that a strengthening economy has all but wiped out that danger and has started to fan talk of inflation?
Greenspan has sought to convince the markets that he'll stand pat for quite a while, even as the economy picks up steam. But investors, aware of the premium Greenspan places on flexibility, are skeptical. Already, they are driving up long-term rates, partly in expectation the Fed will raise short rates in the spring.
This is not the first time the Fed has faced questions about when to reverse rate cuts. After it cut rates in the Russian debt default, economist Alan H. Meltzer says, it waited too long to reverse course in '99. The economy built up such a head of steam that it took much higher rates and a recession to cool it off. Some economists fear that in promising to keep rates low for a while, Greenspan will either box the Fed into making the same mistake again, or do further damage to its credibility by reversing course.
To his credit, Greenspan is trying to explain his vision of monetary policy. But after years of playing the role of cryptic central banker, he has a ways to go before earning the title of communicator-in-chief.
By Rich Miller