Greenspan's Dilemma

The more confident investors are in him, the harder his job becomes

Since taking office as the nation's top banker 13 years ago, Federal Reserve Chairman Alan Greenspan has managed to foster ever-stronger confidence. Through stock market crashes, global financial crises, and the emergence of a New Economy in which the old rules about growth and productivity have gone out the window, he has fine-tuned Fed policy with nary a miss.

But now the Fed chief may be suffering from a rare malady: too much credibility. Investors have so much faith in Greenspan's ability to keep the economy growing rapidly without inflation that they're ignoring all his bearish warnings about the need to slow growth. Shrugging off the Fed's rate hikes, they're snapping up stocks and bonds as if today's white-hot growth and extremely low inflation are a permanent condition.

Call it exuberant irrationality: On Mar. 21, the day of the Fed's latest quarter-percentage-point increase in the target federal funds rate, the Dow Jones industrial average soared 227 points. Bond prices rallied across the board, pushing the 30-year Treasury bond's yield decisively below 6% to its lowest level in seven months. Behind the rally: relief that the Fed didn't raise short-term rates by a half point--and confidence that the good times will keep rolling. "The central bank's credibility is very high right now," says Chris Conkey of Evergreen Investment Management in Boston. "There's a strong sense the Fed is on top of things."

But the more confident investors are in Greenspan, the harder his job becomes. Soaring stock prices and falling long-term interest rates are fueling the supercharged economy and frustrating the Fed's efforts to slow growth down to more manageable levels. And Greenspan deserves some of the blame, because his own overly complicated explications of monetary policy have left many investors stumped. Indeed, some argue that if Greenspan really wants to cool the economy, he's going to have to make a bigger or unexpected increase in rates. "The Fed needs to tighten much more aggressively," says Greg Jensen of consultant Bridgewater Associates.

ON MESSAGE. Greenspan's not about to do that. Somehow, though, he needs to persuade investors there really is something to worry about even though there is no sign of actual inflation outside of skyrocketing oil prices. In speeches and congressional testimony, he has advanced a number of rationales for raising rates. But far from clarifying matters, he has sown confusion about the Fed's intentions.

Perhaps the Fed chairman could learn something from politicians about staying "on message." He says productivity growth is shielding us from inflation, and techies cheer. Then he muses that this same productivity may be goosing the stock market and thus overstimulating the economy, and the catcalls begin. Greenspan vows to raise short-term interest rates until the economy slows. But in the same breath he argues that it's private investors, not the Fed, who really set market interest rates. He talks about the desirability of the stock market taking a breather, yet insists that he's not targeting stock prices.

With apologies to the scriptwriters of the film Cool Hand Luke, what we have here is a failure to communicate. It's not that Greenspan has blown the job--to date, he has delivered brilliantly on the Fed's mission of keeping inflation low and growth strong. The risk, experts say, is that the muddle over his message could make it harder for the Fed to justify further rate hikes to prevent the economy from overheating. While Greenspan isn't elected, he is sensitive to the popular will--especially in a Presidential election year. If he can't convince the public that slower growth is needed, "he could end up erring on the side of doing too little rather than doing too much," says William Dudley, chief economist at Goldman, Sachs & Co.

But communications problems aside, associates say that Greenspan remains convinced that the Fed's drip-drip-drip approach to raising rates will succeed in keeping things in balance. And while he is optimistic that he has a handle on the New Economy, there's no doubt that he is trying to set policy in extremely confusing times. After nine boom years, and despite five rate hikes, growth continues to race ahead at an astounding pace. First-quarter growth now looks to be 5% or more. And that's on top of what could be an upwardly revised, mindboggling rate of close to 8% in the final quarter of last year.

At the same time, the huge productivity gains wrought by technology have made it far harder to suss out the right policy response to that growth. With productivity up by more than 6.5%, unit labor costs actually fell in the fourth quarter of 1999 despite record-low unemployment. Prices, too, seem under control. Consumer prices, excluding food and energy, rose at an annual rate of just 2.1% through February. Greenspan also sees no signs of an inflation-fueling pickup in wage demands.

BASIC TRUTHS. Those conflicting signals make it all the more imperative for Greenspan to get his message across more clearly. Many investors are persuaded that Greenspan has turned sour on productivity and is directly targeting the stock market. Yet Fed insiders insist that neither is the case. In truth, Greenspan is perhaps the biggest believer inside the Fed that productivity growth is continuing to accelerate, raising the economy's noninflationary speed limit and bringing benefits to employers and employees alike. He's also among the most skeptical of the Fed's ability to second-guess the stock market, although he does note that the central bank must take Wall Street's impact on Main Street into account when setting rates.

Cut through Greenspan's elaborate explanations and you end up with Economics 101: supply and demand. Demand for capital is booming as companies rush to invest in productivity-enhancing equipment. But the supply of personal savings is contracting as confident consumers spend more of what they earn. With demand for capital outstripping supply, Greenspan figures the cost of money--interest rates--needs to go up.

Greenspan sees the same pressures on the output side of the economy. Demand for goods and services is outpacing supply. So the unemployment rate is falling: U.S. companies are having to dig deeper into the labor pool to produce more goods and services. And since U.S. companies can't satisfy all the domestic demand, imports and the trade deficit are rising. Again, higher rates are the way to slow demand.

In keeping an eye out for signs of trouble, Greenspan is focusing on profit margins as well as prices, Fed insiders say. If margins start to feel the pinch from rising raw material or labor costs, that could lead to some rough sailing for the economy. Pressures on margins are a harbinger of either higher inflation or lower profits, both of which could jeopardize the expansion.

IN THE VISE. So how is the battle to balance supply and demand going? If you look at the demand side of the economy, there seems to be reason to worry. The stock market is still rising, making consumers feel wealthier and thus stimulating their spending. The Wilshire 5000 Total Market Index--the broad measure of stocks that Greenspan follows--is up 23% in the past year, and up 15% since the Fed began raising rates last June. Interest rates are a problem for Greenspan, too. Long-term rates, after rising for much of the past year, have recently begun to turn down (sidebar). That threatens the Fed's efforts to engineer a slowdown by keeping borrowing strong and the economy hot.

The picture is brighter on the supply side. Productivity growth is strong, raising the ability of companies to produce what consumers are demanding. And the federal budget surplus is booming, raising the supply of savings.

Greenspan hopes the New Economy will increase its output of goods and services rapidly enough to accommodate strong demand. But if it doesn't and inflation starts to gather force, the Fed will really have to tighten the screws--even at the risk of causing a serious slowdown in the economy. Then the fruits of exuberant irrationality will be all too evident.

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