Was Greenspan Too Lax?

Some economists say he let the party go on too long

From one end of Corporate America to another, you can't find an executive who has anything but admiration for Federal Reserve Chairman Alan Greenspan's deft nurturing of the U.S. economy. But amid the high praise are growing murmurs of concern that he has let the good times go on for too long and now risks tipping over the economy.

With gross domestic product rising at an astonishing annual rate of 6.9% in the fourth quarter of 1999, the worry on Wall Street--and among a few anti-inflation hawks at the Fed--is that Greenspan has allowed the unemployment rate to fall too low, the stock market to rise too high, and too much liquidity to slosh around the system. To keep inflation in check, Fed watchers say he may need to raise interest rates by much more than the two quarter-point hikes many investors expect.

According to this line of reasoning, the Fed can't simply slow growth to the new speed limit of 3 1/2% to 4% a year. Instead, it has to engineer what economists call a "growth recession"--lowering annual growth to as low as 2% for a couple of years. That would reduce pressure on labor costs by increasing unemployment and also lower capacity utilization, thus preventing production bottlenecks. Both would help avert an inflation spike that could derail the expansion.

The chorus of criticism of the Fed has grown louder the more exuberant the economy and financial markets have become. The Nasdaq Composite Index has soared 15% in the first two months of the year after climbing by a jaw-dropping 85% in 1999. Consumer confidence is hovering around its highest level in a generation, while the jobless rate is at just about its lowest. And manufacturing is strong, with the National Association of Purchasing Management's factory index rising to 56.9 in February from 56.3 in January. "There's a lot of pent-up pressure in the economy," says Tim O'Neill, chief economist for Harris Bank/Bank of Montreal. "The Fed has to tighten enough to bring growth down to 2%."

To be sure, there are scattered signs that the Fed's repeated rate hikes--and the threat of more--are having a sobering effect on financial markets and the economy. Existing home sales fell nearly 11% in January as higher mortgage rates began to bite. And many stocks outside of the charmed circle of the Nasdaq have suffered. The Wilshire 5,000 index--the broadest measure of the stock market and a favorite gauge of Greenspan--has been flat this year.

NO CONFIDENCE VOTE. But is it enough? A growing number of economists say no. Some argue that when rising values of stocks and housing are considered--using a measure known as the Broad Price Index--inflation is double the 2.6% rise in the Consumer Price Index. Those who think inflation isn't a problem yet argue that the Fed has to act more forcefully now because monetary policy works on the economy with a lag. A survey last month by the National Association for Business Economics (NABE) found that 32% of its members believe policy is too easy--the highest vote of no confidence in the Fed since 1995.

The criticism of the Fed comes from three camps of economists: labor traditionalists, who say the unemployment rate has fallen too far; monetarists, who believe money-supply growth has been too rapid; and bubble bears, who fear stock prices have risen too much. With 4% unemployment, traditionalists fret the Fed let the economy enter a danger zone where mounting wage pressures fuel inflation. They argue the jobless rate has to rise toward--and perhaps above--5% to keep inflation in check. "The Fed may get the economy to slow [to its speed limit] and think it's done," says Chris Varvares, president of consultants Macroeconomic Advisers in St. Louis. "But the pressure in the labor markets may still keep rising."

TOO MUCH MONEY. The monetarists, too, worry that the Fed may have been lax. "The Fed has been pumping in too much money," says Mickey D. Levy, chief economist for Bank of America Securities. The monetary base--currency plus reserves in the banking system--exploded at an annual rate of more than 30% in the last four months of 1999. Some of that money probably helped juice up the stock market in the closing days of 1999, monetarists say. Much of the growth came as the Fed and commercial banks tried to protect themselves from Y2K disruptions. The money supply has since shrunk, but more needs to be done, critics say.

For the bubble bears, the concern is the stock market, not the money supply. They worry that the Fed let a stock market bubble develop that could burst and hobble the economy. "The situation in some sense is out of control," frets Albert M. Wojnilower, senior adviser to the Clifford Group, a private equity firm. The bubble bears say the Fed should have noted rising asset prices sooner as a harbinger of trouble.

Some Fed insiders share these concerns. The minutes of the central bank's policymaking meeting on Dec. 21--the latest records available--indicate a "few members" worry inflation will heat up if the unemployment rate doesn't rise. These naysayers were--and are--in the minority on the Federal Open Market Committee. Greenspan reassured lawmakers on Feb. 23 that the Fed was not out to slow the economy to below its trend and push up the unemployment rate. He believes the productivity bonanza has changed the rules.

Even Fed critics admit Greenspan may have little choice but to follow his conservative strategy. With traditional measures of inflation quiet, he would have trouble justifying rate hikes that would slow growth sharply. But the risk is he may end up with inflationary egg on his face.

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