The Fed's New Rule Book

The premise for rate policy now: Productivity is curbing inflation

For two years, the Federal Reserve has been struggling mightily to fit what has been happening in the U.S. into traditional economic models. Growth was robust, stocks were soaring, job markets were tightening--yet inflation was nowhere to be found. Quarter after quarter, the pattern held. And try as they might, Chairman Alan Greenspan and the Fed's governors couldn't explain it using the old rules. Now, they have simply stopped trying.

Just within the past few weeks, a majority of Fed officials have rallied around a new consensus view: The nation is in the throes of a technology-driven productivity boom that is letting the economy grow faster than once thought possible without setting off growth-strangling price and wage hikes. Sure, unemployment stands at a 29-year low, the U.S. expansion seems inexhaustible, and money supply is growing rapidly. But with inflation well in retreat, these indicators can no longer be read in the same


Now what? The Fed has decided to set some new rules. Not only are the changes intended to align policy with the new reality, but they are aimed at making the Fed's intentions easier to read. Instead of pouncing before the first discernible sign of inflation, as Greenspan & Co. did in 1994, the Fed will be more inclined to wait. "The Fed is moving in a very different direction," acknowledges former Fed Vice-Chairman Manuel H. Johnson. "You'll probably see less tightening in the future." And instead of keeping policy shifts at Federal Open Market Committee meetings--aside from outright rate changes--secret for weeks, the Fed plans to make sure the markets know promptly if it is leaning toward a future rate hike or cut.

That doesn't mean the Greenspan Fed has gone soft on inflation. But it has all but ruled out a preemptive strike. Absent unmistakable evidence that the economy is really overheating and driving up prices and labor costs, the Fed will be content to sit on its hands--and telegraph any changes in its thinking well in advance of a rate move.

On the other hand, the Fed may still be preemptive when it comes to keeping the economy from falling into recession. Fed officials clearly seem ready to consider further cuts, such as the three administered last fall, if a new financial crisis overseas threatens U.S. prosperity.

These changes have been in the works for more than a year. But implementation was accelerated dramatically in recent weeks as statistic after statistic revealed an economy that is operating far beyond expectations of even the most optimistic forecasters.

The key to the Fed's new thinking is a new consensus around the belief that productivity growth--which languished at 1% during the 1970s and '80s--has taken a long-term leap to 2% or more as companies use information technology to become more efficient. Greenspan first spotted a rising productivity trend line in 1997, but most of his colleagues argued that it was an anomaly resulting from the strong economy and lucky circumstances, such as falling oil prices.

No more. This spring, one top Fed official after another has embraced the argument that the adoption of productivity-enhancing technology has changed the way the economy operates. "Is this rise in productivity cyclical because the economy is strong, or is this a change in the trend?" asks Fed Governor Roger W. Ferguson, who had been a leading doubter. "The evidence is mounting that it's a change in the trend."

That conclusion is echoed by a clear majority of Fed policymakers, who include the six members of the Board of Governors in Washington (there is one vacancy) and the 12 presidents of the regional Fed banks. "My earlier position was that the evidence for a convincing breakout of productivity wasn't there," says St. Louis Fed President William Poole. But in an Apr. 16 speech, he concluded: "It is increasingly reasonable to believe that the U.S. has indeed turned the corner on productivity growth." Poole quantifies the new long-term productivity rate at around 2%--double what he previously believed.

SPEED LIMIT. The consequences of that change are enormous for Fed policymakers. It means the economy can grow 3% or more a year without generating higher inflation, not the 2% that the Fed has long believed was the economy's speed limit. An extra 1% growth a year translates into a gross domestic product that is $1.1 trillion higher a decade out.

Greenspan and his colleagues continue to hold a healthy degree of skepticism about the duration of this productivity boom. But they see it as the only explanation for the lack of wage and price hikes in the face of an economy growing at nearly 4% with such low unemployment. Inflation has actually dropped--to around 1.5% a year. "The fact that there's been so little inflation means you don't need a hair trigger here," says Vice-Chair Alice M. Rivlin. "There's more time to act."

That extra time will come in handy. The FOMC is now working in uncharted economic territory, and predicting the course of the economy is trickier without the old signposts. "If you're not as sure about the structure of the economy, it's completely reasonable that the Fed be more cautious," notes Columbia University business school Professor Frederic S. Mishkin, former research director at the Federal Reserve Bank of New York. Indeed, Dallas Fed President Robert D. McTeer Jr., in one of the most unusual tributes given to a fellow professional inflation-fighter, hailed Greenspan in March for showing the "courage not to tighten when he believes the forecasts of rising inflation are wrong or premature."

The Fed's new rule book also includes a chapter on the growing impact of global economics. For example, plunging commodity prices resulting from the slump in Asia helped cut inflation in the U.S., leading to robust growth and a bull market. But the international financial crisis also caused near-panic in U.S. markets when developing economies faltered last September. That prompted the Fed to cut rates to avert a credit crunch that could have triggered a global recession. More recently, the combination of strong consumer demand at home and continued weakness in Asia, Latin America, and Europe sent the U.S. trade deficit surging to a record $19.4 billion in February. That unexpectedly high gap has prompted some forecasters who had expected a 4% first-quarter growth rate to shave their estimates by a half-percentage point or more.

VIGILANCE. Little wonder the Fed is factoring in international developments more than ever in determining the best course of action for the U.S. And though the international crisis that gripped the world a year ago appears to have receded, the Fed is no less vigilant today about new dangers abroad, whether a currency crisis or threat of deflation. "Brazil is still a worry, and until Japan recovers, one can't be certain about the rest of Asia," says Rivlin.

In the face of all this uncertainty, FOMC members are now counting on the markets to help regulate the economy for them by raising and lowering long-term rates to keep inflation in check. Remember when bond rates approached 6% in March on unfounded fears of an imminent Fed rate hike to slow the economy?

To better guide the markets, the formerly secretive rate-setters--who would keep their "bias" under wraps for as much as six weeks--have decided to go public with changes in their thinking about whether they might soon raise or lower rates. The new openness, senior Fed officials privately acknowledge, may well amount to "virtual" monetary policy--the Fed could avert a rate hike if the markets react as if it had tightened, causing the economy to slow on its own before the Fed needs to act.

But the announcement of policy tilts could deprive Greenspan of a way to appease would-be dissenters within the Fed. In the past, when FOMC members were pushing hard for rate hikes, Greenspan won their support for staying pat by agreeing to adopt a bias toward tightening down the road even though he doubted the need to follow through. "Under this new openness, you won't get all those frivolous biases anymore," predicts former Governor Wayne D. Angell, now chief economist at Bear, Stearns & Co. "They won't change direction as often."

MONEY-SUPPLY GROWTH. Greenspan may regret the loss of a political tool, because the debate over the New Economy at the FOMC hasn't disappeared altogether. Even officials who now believe that the productivity boom allows the economy to grow faster without inflation see limits to this theory. Poole, for one, remains a diehard monetarist who still worries that overheated money-supply growth will guarantee future inflation. Likewise, Fed Governor Laurence H. Meyer is still not willing to concede that productivity removes all dangers of inflation with exceptionally low unemployment.

Still, it's hard to fight the data, which have been going Greenspan's way. And that's why most of his colleagues have come around to his view. "A year ago, he had to use all his skills and tricks to keep his colleagues on board," says Boston College economics professor Alicia H. Munnell, a former member of President Clinton's Council of Economic Advisers. "His job will be easier now."

So long as the numbers continue to bolster his case, Greenspan's view will continue to prevail. And eventually, the quiet revolution he sparked will become business as usual at the Fed.

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