Inside the Fed's First-Aid Kit

If rate cuts aren't enough, there are alternatives

President Bush isn't the only one who has a lot riding on the war with Iraq. Federal Reserve Chairman Alan Greenspan does, too. In deciding to hold rates steady on Mar. 18 despite mounting signs of economic weakness, Greenspan in essence made the same call that suddenly bullish investors did, sending the Standard & Poor's 500 stock index soaring 8.5% between Mar. 13 and 19.

He's betting that a quick U.S. victory will dispel the gloom hanging over the economy and clear the way for a robust recovery later this year.

Which isn't to say the economy's ills are behind us. In announcing their rate decision, Fed policymakers also said they were on "heightened" alert, ready to ease credit if the war goes awry. Besides, not everyone at the central bank is as sanguine as Greenspan about the postwar economy. Some don't buy the Fed chief's argument that the economy's ills stem only from Iraq-induced geopolitical jitters. They fear the U.S. is still hobbled by '90s excesses, which left companies with too much capacity and consumers with too much debt.

Those differences didn't surface at the Mar. 18 meeting. But Fed uncertainty did show up in its postmeeting statement, when the Fed declined to say whether it thought risks to the economy lay in higher inflation or weaker growth. That's the first time the Fed has refused to assess the economy's risks since it began doing so three years ago.

If Greenspan's instincts prove correct, he and the economy will be out of the woods. But if he's wrong, the Fed chairman will be in a bind. With the federal funds rate, the rate that banks charge one another for overnight loans, at a 41-year low of 1 1/4%, there's little room to act. "The Fed has done about all it can do when it comes to cutting," says Alice M. Rivlin, a former Fed vice-chair who's now at the Brookings Institution think tank.

That's why some Fed insiders are thinking about ways other than trimming short-term rates to revive the economy. For now, the talk is theoretical: It would probably take a relapse into recession and one more rate cut before the Fed would consider taking other measures. "[But] being the prudent people they are, they're planning for the contingencies," says Princeton University professor Alan Blinder, himself a former Fed vice-chair.

At the top of the list of emergency measures: buying Treasury notes and bonds in the market to yank long-term rates down. Although long-term rates are also at historic lows, they're still well above short-term numbers. The strategy has a mixed record. During World War II, the central bank did manage to hold down long-term rates to help pay for that conflict. But when the Fed tried to manipulate long-term rates in 1961 in a move called Operation Twist, it had little success, because its bond purchases weren't that big.

Talk of bond-buying could prove academic if a rebound occurs. But just in case Greenspan is wrong, it's worth the Fed's considering an alternative.

By Rich Miller in Washington

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