Why Greenspan Isn't That Worried

Some of his colleagues see looming inflation risks. But the Fed chairman isn't likely to shift gears

As The Federal Reserve prepares to hold its first monetary meeting of the year on Feb. 1-2, financial markets are bracing themselves. Investors fret that Alan Greenspan and his central bank colleagues are about to junk their go-slow strategy of bite-size interest rate hikes in favor of something more aggressive. And that uneasiness is certainly understandable given what the minutes of the Fed's last meeting on Dec. 14 showed. According to that record, some policymakers are openly anxious about a breakout of inflation. Other officials, in a throwback to Greenspan's irrational exuberance comments of yore, are working the worry beads over what the minutes call "excessive risk-taking" in financial markets.

What's fueling those concerns? The minutes -- which don't identify the worrywarts -- point to the return of corporate pricing power, a weak dollar, still-elevated energy costs, and slowing productivity growth as signs that price hikes could soon accelerate. And in the financial markets, Fed officials cited low corporate bond yields and recent pickups in initial public offerings and mergers and acquisitions as indications that easy money is fueling speculation. So it's not surprising that some policymakers are uneasy with the repeated assertions that rate hikes will be measured. They are warning that the Fed may need to be more aggressive. "At some point the measured language will come out of the Fed statement," Federal Reserve Bank of St. Louis President William Poole told reporters after a Jan. 13 speech. "There would be a pretty vigorous reaction [by the Fed] should we see [inflation] threaten to move to a sustainably higher rate."


But those concerns don't seem to have fazed the man atop the Fed. Associates say the chairman has shown no signs of panic and appears content with the strategy of small, slow rate hikes -- one-quarter of a percentage point at each meeting. By more than doubling the short-term rates it controls, from 1% last June to 2.25% today, the Fed has already drained much of the stimulus it pumped into the economy after the stock market bubble burst and terrorists attacked on September 11. Indeed, with another quarter-point hike expected at the Feb. 1-2 meeting, short-term rates will be inching closer to levels where some Fed officials might even consider taking a break from their rate-hiking campaign. "Interest rates clearly are not at restrictive levels," Minneapolis Federal Reserve Bank President Gary H. Stern said in a speech on Jan. 18. But, he added, "if we keep inflation low, I don't see any reason why interest rates should reach particularly high levels."

Buttressing Greenspan's view: Despite the steady rise in short-term rates, financial markets have stayed calm. Stock prices have risen, and bond yields are actually lower than when the Fed started raising rates in June.

In previous expansions, falling long-bond rates often signaled the market's concern that the economy might be weakening. That's unlikely to be the case this time. The economy, in fact, looks pretty good. Business has shrugged off a jump in oil prices, and gross domestic product looks set to grow 3.5% to 4% in 2005, Fed officials say. Although inflation has crept up some, it remains well-contained. Excluding volatile food and energy costs, core consumer prices rose just 2.2% in 2004. "We haven't seen any worrying rise in inflation at this point," Fed Governor Edward M. Gramlich told reporters on Jan. 12.

While there are differences at the Fed over the risks of inflation, central bank officials insist that it would be wrong to exaggerate them. Most of the Dec. 14 meeting was in fact spent discussing the Fed's growing confidence in the durability of the economic upswing. But that conclusion caused little divergence among policymakers and was given short shrift in the minutes. As a result, more of those were devoted to the discussion of inflation, magnifying the importance of those differences. That emphasis may also have led some investors to conclude that the Fed is more worried about a rise in inflation than appears to be the case, Fed insiders say.

What's critical is what Greenspan thinks. While his influence may dim the closer he gets to stepping down next January, Fed insiders say he remains first among equals. Throughout his 18-year Fed career, Greenspan has focused like a laser on productivity growth, labor costs, and profit margins in trying to determine the outlook for inflation. Now is no different.

The message from those key indicators? Inflationary pressures may be building, but gradually. Yes, productivity growth has slowed to a 1.8% annualized pace in the third quarter of last year, the latest period for which data are available. But that slowdown is from extremely strong levels that Greenspan long thought were unsustainable. Excluding farming, productivity grew at a 4.4% clip in 2002 and 2003, a pace that puts even the New Economy of the 1990s boom to shame.

And sure, unit labor costs have turned up as productivity growth has slowed. But that's after costs fell in both 2002 and 2003, the first back-to-back yearly decline since the early 1960s. Labor compensation -- wages and benefits combined -- is growing steadily, at around 4% annually, and shows scant signs of accelerating. That's not a big surprise given the modest jobs growth so far in this recovery.

Profit margins, meanwhile, look to be leveling off after sharp jumps last year. It was that rise in profit margins that Greenspan identified as the culprit behind last spring's pickup in inflation. But as execs gain confidence and become more aggressive, competition for market share will heat up. That will limit companies' ability to pass on their added costs to customers. The likely result: a squeeze on margins and a cap, at least temporarily, on inflation. And that seems to be the message from the monthly survey of small companies by the National Federation of Independent Business. It shows that pricing power peaked in June of last year.


Of course, inflation risks would look a lot different to Greenspan if the central bank hadn't already removed plenty of its monetary juice from the economy. When the Fed began tightening credit last June, policymakers said they wanted to raise ultralow interest rates back to equilibrium levels where monetary policy is neither stimulating nor holding back the economy. What exactly that level is, though, isn't clear. Greenspan has said he'll know it when when he gets there.

But other policymakers have suggested that monetary policy will be in neutral when rates hit the range of 3 1/2% to 4 1/2%. If the Fed goes ahead and raises short-term rates to 2 1/2% on Feb. 2, it will be within hailing distance of that objective. "The Federal Reserve has already begun to make the transition from an accommodative policy stance to a neutral one," said Anthony M. Santomero, president of the Federal Reserve Bank of Philadelphia in a speech on Jan. 18.

Yet even as the Fed has tightened its stance, financial conditions in the markets have turned looser. Long-term interest rates have fallen, stock prices have risen, and the dollar has ebbed. Together, that has given extra oomph to the economy, more than offsetting the impact of the Fed's rate moves, says Goldman, Sachs & Co. (GS ) chief economist William C. Dudley. That's why he and others in the markets argue that the Fed might need to raise rates further than planned.

That argument is unlikely to sway Greenspan. Under his tutelage the Fed has always been reluctant to target any measure of financial conditions, says ex-Governor Laurence H. Meyer. Instead it focuses on why asset prices are moving and what impact they'll have on the economy. Stocks have risen over the past year on growing optimism about the economy. That heightened hopefulness has also boosted initial public offerings and mergers and acquisitions. Meanwhile, bond yields, including those on corporate debt, have fallen, in part in the belief that inflation will stay low. It's not clear why any of that should particularly concern the Fed as long as the economy looks healthy.

Fed officials are paid to worry -- and Greenspan is no exception. But as he swings into his final year astride the world's economy, he appears to be about as relaxed as any central banker can be.

By Rich Miller in Washington

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