Commentary: Making Sense Of The Swirl Facing The Fed

These days, Federal Reserve Chairman Alan Greenspan is like a bus driver on an unfamiliar route. At every intersection, the passengers loudly debate whether he should turn left, turn right, or go straight. He thinks he knows the way, but his map is sketchy.

Unfortunately for the Fed chairman, there is no landmark, no simple rule that will lead him unerringly to the right course. There are only clues. To his credit, Greenspan considers all of them, even those that defy conventional wisdom. For instance, theory says inflation accelerates when unemployment shrinks, but for months Greenspan has heeded data showing little inflation and has resisted slamming on the brakes.

Now, though, Greenspan is signaling that the Federal Open Market Committee will raise short-term interest rates at its next meeting on June 30, and many investors worry that more hikes may be in the offing. No one knows exactly what's going through the minds of the nation's chief central banker and his colleagues on the FOMC. But here are some of the factors they are no doubt considering:

-- The first factor, of course, is inflation. In congressional testimony on June 17, Greenspan criticized the consumer price index and said he prefers another measure of inflation, the price index used in calculating personal consumption expenditures in the quarterly gross domestic product report. The PCE measure of inflation is usually lower because it captures consumers' ability to substitute less-expensive alternatives in response to price increases. But neither measure is pointing to rising prices. In the first quarter, the PCE index rose at an annual rate of 1%, vs. 1.7% for the CPI.

-- Greenspan also has given short shrift to money-supply growth of late because it has been a poor predictor of inflation in recent years. But some economists blame that on problems in the banking system. Now that banks are healthy, says Salomon Smith Barney economist Robert V. DiClemente, the money supply is once again a valid indicator. He thinks the past year's 7% growth in the monetary aggregate known as M2--cash, checking, and money-market accounts--presages a jump in consumer prices.

-- One way excess money growth could show up is in reckless lending by banks and inflation of financial-asset prices. Greenspan does worry about speculation in the stock and bond markets but says he won't raise interest rates just to keep speculative bubbles from forming. Why? Because, he says, there's no way to outguess the market. In any case, no alarms are sounding. Stocks have gone sideways of late, and bond prices are well off their highs.

-- Gold prices usually rise when inflation threatens to erode the dollar's value. Instead, they have plummeted by one-third in the past five years, to their lowest level since 1979. In his congressional testimony on June 17, Greenspan called it "a reflection of a global reduction in the long-term inflation outlook."

-- Traditionally, industrial capacity utilization is one of the best early warning signs of inflation. By that measure as well, there's nothing to worry about: It's hovering around 80%, which is not far above recession levels.

-- The unemployment rate is a different matter. At just 4.2% in May, it's far below the level at which most economists would expect inflationary overheating. One explanation for why wages haven't surged is that employers have hired people who had not been actively looking for jobs. So lately, Greenspan has focused on an alternative measure: the pool of available labor, which includes both the unemployed and those who are not in the labor force but might like to work. According to Stone & McCarthy Research Associates in Princeton, N.J., that pool in May was the smallest it has been for that month since the 1970s.

-- Anecdotal evidence may not impress statisticians, but Greenspan & Co. take it seriously. The Fed's June 16 summary of regional economic conditions, known as the Beige Book, mentioned a temporary-help agency that was offering administrative workers in the Midwest a 25% pay raise since the start of the year. More disturbing: The agency was passing on the higher costs to customers.

Add it all up--and throw in dozens of other data ranging from overseas growth rates to consumer spending to unit labor costs--and you have one very mixed picture of the outlook for inflation. In such circumstances, it would be wise for the Fed to move slowly. If inflation does creep up, it will be easy enough to beat back down. But if the Fed raises rates too much or too soon, it could kill the nascent global economic recovery. Of course, everyone's got an opinion. But only one matters--the one held by the man driving the bus.

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