Monday Morning Quarterbacking At The Fed

Alan Greenspan has practically copyrighted the ambivalent phrase "cautiously optimistic." But on Mar. 3, the Federal Reserve Board chairman didn't waffle, if only for a moment. Looking back on the Fed's handling of the economy during three years of sluggish growth, financial shocks, and a recession, Greenspan declared he wouldn't have changed a thing. "I honestly cannot say that we did something which I'd like to go back and revisit," he told Congress' Joint Economic Committee.

Indeed, while Congress and the Administration gripe that the Fed didn't do enough to fight the 19-month recession, central bankers defend their record, saying they were maneuvering through an uncertain world of financial instability. Even so, the charges have sparked an internal Fed debate over how the institution should change to nurture the newborn expansion.

Insiders acknowledge, for instance, that the Fed needs to pay more attention to developments in the financial system. Despite the obvious distress last year in the banking industry, the Fed failed to realize that banks would be reluctant to lend--even when the central bank was providing a flood of new money. The resulting credit crunch helped choke off last summer's fledgling recovery. Then, policymakers lost weeks debating whether a slowdown in money-supply growth was real or illusory (chart).

GLOOM. When the Fed finally reacted, Greenspan's repeated small rate cuts failed to give the economy the psychological boost it needed. Still, Greenspan, who continues to believe that the gulf war triggered the recession, has no second thoughts. As he sees it, the recession wasn't just cyclical but compounded by businesses and consumers who put the brakes on borrowing, slashing spending, and paying down debt.

Meanwhile, the huge flow of bailout funds moving into the thrift industry confused the money-supply data and misled the Fed. And widespread gloom about the economy's long-term future chilled both consumer and business confidence. Greenspan feels that the Fed faced these problems alone, since the federal deficit ruled out stimulative tax cuts or spending. As the chairman tells associates, the Fed had to use up much more of its ammunition--cuts in rates and bank reserve requirements--than he expected.

But critics question whether Greenspan deployed his arsenal wisely. The Fed cut short-term rates a lot--from 8.5% to 4%--but slowly, in 16 small steps over two years. "If they had eased the same amount, but sooner, the economy would have recovered months ago," says Darwin L. Beck, financial economist for First Boston Corp.

WAITING GAME. The timid easing frustrated even those who felt that some caution was justified. In meetings last fall of the Federal Open Market Committee, presidents of the regional Fed banks raised reports of economic hardship. "Then Alan would say: 'I agree that we need to act, and I recommend a quarter-point cut,' and they would all just nod," says one staffer. Those tiny cuts never registered with the public and conditioned the markets to wait for more cuts. "People were looking for some leadership, and it didn't come," says a former Fed governor.

The issue was finally forced in mid-December. "The markets were telling us: `Figure out where you're going, and get there,' " says a top Fed official. So, with Greenspan's tacit approval, Vice-Chairman David W. Mullins Jr. urged a move that would "ring the bell"--a full-point cut in the discount rate. The Fed's Dec. 20 cut set off the wave of mortgage refinancings, bond issues, and home buying that spurred recovery.

Did the experience doom Greenspanian gradualism? Probably not, but it has launched a debate. Advocates of bolder action note that bond markets rallied after Dec. 20 despite Greenspan's fears that such a large cut would panic traders. "Gradualism is not the only game in town," says a Fed official.

Other lessons from the recession are less controversial. The credit crunch highlighted the need for the Fed to step up its monitoring of banks. And the weak link between M2 and economic growth has led to deeper examination of how the money supply is shaped by shifts in funds from bank accounts to other investments.

But perhaps the most important change at the central bank is the acknowledgment that in a rapidly changing economy, the Fed must constantly reexamine its assumptions. That new flexibility could prove to be good news for a sustained recovery.