Commentary: This Time, the Fed May Resist the Urge to Tighten

By Rich Miller

When it comes to raising interest rates, Federal Reserve Chairman Alan Greenspan has a certain modus operandi: Once he starts to ratchet up rates, he tends to keep right on going. That's the strategy Greenspan followed in 1988-89, when he pushed up rates to nearly 10% after the economy shrugged off the '87 Wall Street crash; in 1994-95, when he doubled rates as the recovery gathered steam; and again in 1999-2000, when he tightened credit six times.

So it's no surprise that investors are betting that Greenspan will follow the same strategy now that he's declared the recession over. After holding rates steady at its next meeting on Mar. 19, the Fed is expected to begin tightening credit as early as May and to doggedly raise the overnight interbank federal funds rate from its current 40-year low of 1 3/4% to 3 1/4% by yearend.

But this time could be different. Why? Because Greenspan wants to make sure the recovery sticks. So the Fed's rate hikes in 2002 could come later than investors think and end up being just half as much as the market expects. "What will make this year unique are the Fed's concerns over the durability of the recovery and very low inflation," says Thomas D. Gallagher, senior managing director of consultants International Strategy & Investment.

Yes, the economy is bouncing back from last year's mini-recession quicker than the Fed expected. In just the past month, Fed officials have raised their forecast for first-quarter growth to close to 4%--a far cry from the 1% to 2% they were anticipating in early February. But like many a CEO, they worry that the economy's strength won't carry through the second half of the year. After all, much of the momentum is coming from a spate of inventory rebuilding that can't last. And with consumers already deep in debt, there isn't much room for a fresh burst of spending.

That means it will be up to Corporate America to propel the economy forward, which will be tough. Facing paltry profits, a flock of topflight CEOs have been complaining to the Fed about lingering weakness in their businesses. Greenspan & Co. consider a revival of corporate confidence and, with it, capital investment, critical to ensuring that the recovery stays robust in the second half.

What's more, with inflation low, there's little reason for the Fed to rush ahead with a series of potentially debilitating rate hikes. In their semi-annual report to Congress on Feb. 27, Fed policymakers forecast that inflation, as measured by the personal consumption price index, would be little changed this year at a mere 1 1/2%. When it comes to inflation, the U.S. is "very much in the neighborhood of what makes sense for the economy in the long haul," St. Louis Fed President William Poole told reporters on Mar. 11. Moreover, some Fed officials are saying privately that inflation could even ebb this year thanks to continued strong productivity. If they are right, real short-term interest rates will wind up higher relative to inflation, even if the Fed does nothing.

None of which is to say that Fed policymakers don't consider the 1 3/4% fed funds rate to be abnormally low. But they're also aware that other factors are canceling out what would normally be stimulus from the low funds rate. The dollar is strong, curbing exports, and long-term interest rates are rising, threatening to undercut what until now has been a robust housing market. In fact, an index compiled by Wall Street brokerage Goldman, Sachs & Co. shows that overall financial conditions--taking account of long and short rates, the dollar, and the stock market--are only slightly more stimulative now than they were at the start of 2001, when the Fed began cutting rates.

Given the uncertainties about the outlook and the quiescence of inflation, Greenspan may be ready to rethink his M.O. and take a more relaxed approach to raising rates. That will give the economy time to blossom, not just with the spring flowers, but through the rest of the year.

Miller covers the economy from Washington

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