What Keeps Greenspan Up At Night

The Fed chairman must fend off the threat of inflation without stealing momentum from the recovery. Can he walk that fine line?

As the Federal Reserve gets set to raise interest rates for the first time in four years, Chairman Alan Greenspan is sounding pretty confident. In testimony before the Senate Banking Committee on June 15, Greenspan said the U.S. looks to be on track for a lengthy economic upturn. "The economy is growing in a solid fashion," he said. "Inflationary pressures are not likely to be a serious concern in the period ahead."

Greenspan's best-case scenario is clear. He'll likely start off with a quarter-percentage-point increase in the federal funds rate, to 1 1/4%, at the Fed's June 29-30 meeting, then follow that up with as many bite-size, easily digestible hikes as needed. His aim is to gently wean the economy and the financial markets off their dependence on cheap money without either quashing the recovery or allowing inflation to reignite.

Still, the task ahead is a lot trickier than it looks. For one, the Fed cannot be sure if the recent surge in inflation is an isolated event or a return to the bad old days of rising prices. High unemployment rates suggest that there's still plenty of slack in the labor market, but a few more months of strong job growth could begin to eat that up. And the continued increase in home prices -- up 7.3% over the past year -- is making it harder to dismiss the possibility of a housing bubble that could burst and cause widespread damage if interest rates rise too sharply.

Then there are the biggest imponderables, productivity and terrorism. On the economic side, productivity is the key variable determining how fast the economy can grow. Yet no one has any idea whether today's heady productivity growth -- averaging 4.5% since the beginning of 2001, close to the highest on record for a three-year stretch -- can be sustained, or how far it may drop.

Uncertainty Factor

On the geopolitical side, a major terrorist strike in the U.S., or expanded conflict in the Mideast, could change monetary policy calculations overnight. Oil prices have already spiked on fears that terrorist attacks will disrupt supplies from Saudi Arabia.

Indeed, given all the things that could go wrong, Greenspan remains wary and ready to change course quickly if events don't unfold as he expects. "Uncertainty is not just a pervasive feature of the monetary policy landscape," Greenspan told lawmakers on June 15. "It is the defining characteristic of that landscape."

What's at stake -- as Greenspan and the Fed try to set monetary policy against that backdrop of uncertainty -- is nothing less than the ability of the U.S. economy to move into a period of sustained expansion. If the fed funds rate can be gradually returned from today's 1% to more normal levels -- say, 4% or so -- without damaging the economy, it would be a tremendous accomplishment. It would mean that the U.S. had successfully weathered a stock market bust of epic proportions, unprecedented terrorist attacks, rampant corporate scandals, and war in the Middle East. The slow pace of rate increases would also keep the Fed out of politics in this fall's elections and set the U.S. up for another round of strong growth.

Such an outcome would cement Greenspan's legacy as one of the greatest central bankers of all time. He would bequeath his successor -- whomever it may turn out to be -- a low-inflation, high-productivity economy. By contrast, if inflation should zoom out of control, or rising rates should disrupt the financial markets and the recovery, it would call into question Greenspan's unconventional approach to the technology-driven New Economy: letting the boom run as long as possible to stimulate growth and investment, quickly slashing rates to cushion the impact of the bust when it finally arrived, and then holding rates low to revive growth.

For now, both the economy and Greenspan's place in posterity are looking pretty good. The latest BusinessWeek survey of economic forecasters shows that they expect growth to average a solid 3.8% over the next year. Meanwhile, the inflation rate a year from now is expected to be only 2.2%, well within the usual definition of price stability. Moreover, Greenspan's task today is easier in some ways than it was in 1994, the last time the Fed had to unwind low interest rates. Inflation is lower, productivity growth is higher, and the financial markets seem better prepared for the coming rate hikes.

If Greenspan's go-slow, measured approach works, he will have burnished his reputation in a career that began with his appointment to the central bank in 1987 by President Ronald Reagan, and that will end in early 2006, when his term as a Fed board member expires. Greenspan, now 78, saw the economy through many rough spots, including the 1987 stock market crash, the 1990-91 recession, and the 1997 Asian financial crisis.

Prophet of Boom

But his contribution as a central banker will ultimately be defined by his handling of the technology boom in the late 1990s, the bust that followed, and the current period of uncertainty. Convinced that the economy had entered a new epoch of productivity-powered prosperity in the late '90s, Greenspan held back from aggressively raising interest rates as capital investment boomed and the economy roared ahead. In the process, he countenanced a stock market bubble, especially in tech stocks, that later burst, beginning a three-year slump.

To shelter the economy from the fallout, Greenspan then slashed rates sharply, avoiding any major financial collapses and limiting the decline in gross domestic product to only 0.7 percentage points, a very shallow recession. When the recovery proved hesitant, Greenspan went even further. Faced with what even he admitted was the remote risk of a deflationary downturn in prices, the Fed chief last year cut short-term interest rates to a 46-year low of 1% and promised to keep them down for a considerable period.

Combined with sharp tax cuts, Greenspan's monetary strategy had its intended effect. Over the past year, the economy has raced ahead at a 5% rate, the stock market jumped 17%, and the economy generated 1.4 million new jobs after a long drought. Compared with the aftermath of Japan's economic bust in the early 1990s -- which sent that country into a decade-long tailspin -- the American experience seems positively benign.

Even the pickup in inflation does not seem terribly threatening to the Fed -- yet. True, overall inflation has accelerated sharply to an average annual rate of 5.5%, over the past three months, mainly from higher energy prices. However, core inflation, not including energy or food, is running at a 1.7% rate over the past year, compared with a 1.6% rate a year earlier. That helps explain why most Fed policymakers, including Greenspan and Fed Governor Donald L. Kohn, see the rise in prices as transitory, not the start of a steadily worsening inflation picture.

Moreover, if inflation is rising mainly because companies have regained some pricing power, Greenspan is willing to tolerate it. Why? Because he knows that those price increases will eventually slow down as the lure of fat profits draws more competition into the marketplace. "My guess is that five years from now we'll look back at 2004 as another year of low inflation," Minneapolis Fed President Gary H. Stern told BusinessWeek on June 1. Adds Tom Hoenig, president of the Kansas City Fed, in an interview on June 4: "We still have an environment of relatively modest inflation."

That labor costs, a figure Greenspan monitors closely, remain under control is reassuring to the Fed chief. The latest figures from the Bureau of Labor Statistics show that unit labor costs are down by 0.8% over the past year, a testimony to strong productivity growth.

Fed officials also don't seem terribly worried about demand outrunning the economy's productive capacity soon. True, job growth has finally picked up. But surplus workers and ununused factory capacity still seem to abound, so inflation should be contained. Manufacturing capacity utilization is hovering at 76.4% -- more than three percentage points below its long-run average. And with unemployment still stuck at 5.6% -- even without including the people who have left the labor force since 2000 and stopped actively looking for jobs -- there's enough spare labor to head off pressure for higher wages.

Moreover, Greenspan is encouraged that companies still have plenty of internal financial resources they can tap to expand capacity. The latest data from the Federal Reserve show corporate cash flow running ahead of capital investment. As a result, corporate liquid assets -- things like cash and government securities -- are up by over $100 billion over the past year.

Not everyone is so sanguine. The prevailing wisdom in the financial markets is that the Fed has already missed its chance to head off inflation. Pessimists point to the latest figures from the BLS, which show that core inflation has risen at a startling 3.3% rate over the past three months. As a result, they say, rising prices will force Greenspan to move more aggressively to hike interest rates than he would prefer. "The Fed hesitated too long," says Wall Street veteran Henry Kaufman. "There is inflationary creep in the pipeline." Traders seem to believe that the fed funds rate will move up from 1% today to 1.5% by August, and 2.3% by January, based on interest rate futures contracts on the Chicago Board of Trade. While still quite low by historical standards, such an increase in rates could be enough to puncture the housing market and take some of the wind out of economic growth.

Educated Guesses

Fed officials admit that there's a lot they don't understand about the inflation process. Although Kohn doesn't see prices spiralling out of control, he told the National Economists Club in Washington on June 4 that he had been "surprised by the extent of the pickup in core inflation this year."

A potentially troubling factor is productivity. Fed policymakers did not accurately forecast just how robust it would be over the last three years, and no one, not even Greenspan, seems to have a particularly good explanation why it's so strong. "Trying to predict the underlying trend growth rate of productivity is fraught with difficulty," outgoing Richmond Fed President J. Alfred Broaddus told BusinessWeek on June 7. Nevertheless, Greenspan remains optimistic about future productivity trends, and the best guess of many economists is that productivity growth will eventually settle in around 2.5% per year, a decent number by anyone's standards.

But if productivity growth proves as surprising on the downside as it was on the way up, then the Fed and the economy may be in for some trouble. Over the years, economists have had little luck anticipating future productivity gains. In fact, unexpected changes in productivity growth -- including the sudden slowdown in productivity gains in the 1970s at a time when oil prices were also rising -- account for some of the biggest miscalculations in economic forecasting.

This time, a sudden and unexpected tailing off in productivity could lead to a burst of inflation as companies scramble to raise prices to cover higher labor costs. Indeed, some forecasters are predicting that productivity growth in the second quarter could slow to a 1% pace or less.

Moreover, the amount of excess capacity in the economy is devilishly difficult to measure, Fed officials admit. Some policymakers, including Philadelphia Fed President Anthony M. Santomero, wonder whether rapid technological change means there is less slack in the labor market and in factory capacity than there appears to be. In an interview on June 8, Santomero suggested that a growing number of workers may simply be unemployable because they lack the right skills for the jobs available. In fact, a Philadelphia Fed survey in April of regional manufacturers found that more than 40% of them reported having difficulties in filling job openings because applicants did not have the required skills. Technological innovation may also mean that some of the existing factory capacity is outmoded and not available for use, Santomero said.

Insidious Inflation

Perhaps the trickiest factor determining the future path of inflation is expectations. Inflation is a self-feeding process. If companies and workers are convinced it will remain under control, as Greenspan believes, then the central bank can afford to move at a much more measured pace in increasing rates in response to rising price pressures. But once companies and workers start anticipating rising prices, they act in ways that feed the inflationary spiral. Companies will be quicker to jack up prices, and workers will aggressively press for higher wages to make sure they don't fall behind. "It is very important that we not allow an inflation process to get going," St. Louis Fed President William Poole said in an interview on June 7. "It tends to develop some momentum of its own, and it's expensive to reverse."

That's why some Fed officials want the central bank to junk its pledge of "measured" rate hikes as soon as possible. They fear it's giving investors the impression the central bank won't do what it takes to keep inflation under wraps. Indeed, as measured by the Treasury's inflation protected securities, inflation expectations over the next five years have risen sharply, from 1.3% a year ago to nearly 2.5% now.

But from Greenspan's perspective, every reason to be more aggressive about raising rates seems to be balanced out by an equally compelling reason to go slow. For one, he doesn't want to disrupt the financial markets, as happened in similar periods in the past. In 1994-95, the Fed doubled short-term rates to 6% in a year, leading several hedge funds to go belly up and forcing Orange County, Calif., to file for bankruptcy as its investments went sour. More recently, in 1999-2000, the Fed boosted interest rates by 1 3/4 percentage points over ten months, only to slash rates the following year as the economy went into recession.

The most delicate issue concerns the housing market. While most Fed officials have dismissed talk of a housing bubble, some are beginning to give it more credence as housing prices continue to soar. Kohn, who a year ago argued that rising house prices weren't a problem, now is not so sure. "The odds have risen that these prices could be out of line with fundamentals," he said in a speech in April.

What has got the attention of Kohn and others at the Fed is that the rise in house prices has far outstripped the increase in rents. Rather than renting, people are buying homes at inflated prices and gambling that the prices will continue to rise. One analysis suggests that house prices nationwide may be overvalued by more than 10%, even after taking account of current rock-bottom interest rates.

The implication is that an overly rapid increase in rates could puncture the housing bubble, causing a sharp decline in housing prices. That could hold down consumer spending and growth through the so-called wealth effect.

As Greenspan and the Fed wrestle with finding the right course for monetary policy, President George W. Bush has much riding on it as well. He is running neck and neck with Democratic candidate John Kerry in the polls, and is counting on a strong and growing economy to help him win reelection in November. Administration officials have already given the green light to tighter credit by the Fed, saying the economy can handle small increases in interest rates. But if the central bank had to raise rates aggressively, that would be a major concern. In 1988-89, the Fed raised interest rates more than three percentage points, to close to 10%, over a 13-month period. That helped set the stage for the recession the following year that cost Bush's father reelection.

No one expects the same to happen again. But as Greenspan noted on June 15: "We seem to be on track, but as us duffer golfers like to say, it's not a gimme putt." In an uncertain world, it's still important to remember that monetary policy is tricky and difficult even for the best of central bankers.

By Rich Miller

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