Greenspan's Delicate Game

Did the Federal Reserve really need to cut interest rates for the 13th time since 2001 by another 25 basis points? Probably not. The economy is showing signs of improving, with the stock market up sharply, consumer confidence rising, corporate profits trending higher, and the geopolitical situation growing more stable. With fiscal policy incredibly loose, the dollar weak, and short-term interest rates already down to 45-year lows, normal economic conditions do not call for any more cuts.

To his credit, Federal Reserve Chairman Alan Greenspan worries that we might not be living in normal economic times. He believes that the hoary beast, deflation, which has paralyzed Japan for over a decade, may be threatening American prosperity. Deflation scares him because the U.S. has very little experience in fighting it. So he is trying to prevent deflation from taking root in the first place by taking out some insurance via lower interest rates. More important, Greenspan is jawboning the bond market into believing that the specter of deflation will stop the Fed from tightening monetary policy anytime soon. In effect, he is using a policy of talking interest rates lower and keeping them down. And it's working.

The danger is that Greenspan's strategy is feeding a bond bubble that could pop and hurt the recovery. And by continuously warning about deflation and promising to keep rates low for the foreseeable future, Greenspan may be painting himself into a corner. The bond markets expect ever more rate cuts, and he has to comply or risk bursting the bubble. It's a dicey game. In its most recent rate cut announcement, the Fed again kept the door open for more easing by saying that deflation continues to worry it more than inflation.

The problem is that there aren't that many bullets left in the Fed's arsenal to deal with the problem. Its short-term rates are already down to 1%, and they can only be cut to zero. Talk of following an unconventional strategy to buy long-term Treasuries in order to lower interest rates has faded. Recent research by the Federal Reserve's own staff showed that this unusual maneuver would be much more difficult than previously thought -- and might not work all that well in the end.

The hope, of course, is for Greenspan's policy of taking out extra monetary insurance to work. The goal is for sharply lower interest rates to keep consumer buying high and trigger, at long last, new capital spending and investment from reluctant corporate CEOs. That, in turn, buoys the moribund manufacturing industry, puts new life into the service sector and begins to bring down the unemployment rate. If Greenspan's strategy doesn't work, if a bond bubble develops or if the economy doesn't respond despite all the stimulus, then the U.S. faces real trouble.

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