The Fed May Be Seeing Things

Central bankers are supposed to be dour sorts, and Federal Reserve Board Chairman Alan Greenspan usually plays the role well. But not lately. While the rest of Washington is mired in recessionary gloom, Greenspan is leaning against the winds of pessimism. "As best we can judge," he told the House Budget Committee on Jan. 22, "the latest data contain hints . . . that the downward pressure on activity may be lessening." Translation: The Fed thinks an end to the recession may be in sight.

It's not an easy case to make. Layoffs and bankruptcies are multiplying daily. Factory output sank like a stone in last year's fourth quarter, portending more pink slips. Paralyzed real estate markets on both coasts threaten to take down more large banks. Even San Francisco Federal Reserve President Robert T. Parry admits that he and fellow optimists have scanty evidence. "I've opened every drawer in my desk," Parry jokes, "and I haven't found an upside risk for the economy."

WAR BOON? But Greenspan believes the reams of business and financial data that cross his desk hold signs of an economy hitting bottom. Initial claims for unemployment insurance dropped sharply in early January, while orders for exports remain strong. Auto industry plant closings knocked down gross national product by a full two percentage points in the fourth quarter--but that means, Greenspan argues, that "most, if not all, of the reduction in motor vehicle output may well be behind us." And auto makers aren't the only companies with lean inventories. Any pickup in consumer spending will boost production almost immediately.

Consumer spending could soon pick up--especially if the Persian Gulf war continues to go America's way. The sharp drop in oil prices and stock-market gains that greeted the outbreak of fighting bolstered the Fed majority that blamed the gulf crisis for the U. S. economy's doldrums. "If we can settle this war quickly," says Richmond Fed President Robert P. Black, "the economy might jump back pretty quickly."

A forecast that depends on a quick victory has problems. Some private economists think Greenspan's optimism may be inspired as much by politics as by data. Since war broke out, "Greenspan and the Administration's guys have been speaking from the same script," says David M. Jones, chief economist at bond-trading firm Aubrey G. Lanston & Co. "It's rally 'round the flag."

But pressure is coming at least as much from Greenspan's Fed colleagues as from the White House, and he lost one vote for easing when Fed Governor Martha Seegers announced her resignation. Over the past two months, the central bank has taken six steps to lower interest rates, pumping a flood of reserves into the banking system--to little apparent effect (charts). Now, Fed inflation hawks want a pause to see how the economy will respond. "We're trying this time to avoid sharp reactions that set up conditions for renewed inflation" during the economy's recovery, says Parry. Greenspan's guarded optimism offers a rationale for the central bank to sit tight for a while.

While bowing to the hawks, however, Greenspan is trying to ensure that the central bank will be more responsive to signs of continued economic weakness. The Fed chief is focusing attention on the money supply, which has remained flat despite the Fed's efforts to pump up growth. Since the mid-1980s, the Fed has downplayed the links between M2, its prime measure of the money supply, and the health of the economy. Now, the Fed is worried that weak money growth signals troubles in the financial system.

FAINT SIGNS. The roadblock was in the banking system. Under pressure to boost capital, banks have shrunk loan portfolios, which forced a matching decline in deposits and stalled money-supply growth. As yearend approached, banks wanted to keep their funds close at hand: First Interstate Bancorp of Los Angeles, for example, retired $ 1.8 billion of its commercial paper during 1990, then built up a $ 1 billion cash reserve to bolster liquidity. With war fears running high, individuals pulled money out of banks and fled to Treasury securities. The result: Little of the Fed's intended stimulus has gotten through to the economy.

Now, Greenspan sees faint signs that the credit crunch is ending: Healthier banks, he argues, are beginning to snatch their weaker sisters' loan customers. If that continues, the gains should be reflected in M2. If it stalls, the ongoing slowdown in money growth will help Greenspan convince Fed hawks that more easing is necessary--in a hurry. "Problems will show up in money measures long before they hit the economy," says Jerry L. Jordan, First Interstate's chief economist.

Greenspan had better hope so. His optimism, tentative though it may be, has many Fed-watchers worried that the central bank will overlook any contrary evidence. "So far, the economy has fallen faster than the Fed has eased," frets David Wyss, financial economist for DRI/McGraw Hill. Greenspan would argue that his new forecast puts him ahead of the curve. It will take several nerve-racking months to see if he's a forecasting genius or an economic goat.