How to End the "Measured Pace"?

When Greenspan & Co. adopted that term to describe the future of rate increases, they set themselves up for the tough job of abandoning it

By Rich Miller

In the summer of 2003, Federal Reserve Chairman Alan Greenspan and his central bank colleagues all but promised to keep interest rates low "for a considerable period." When they did that, they knew they were embarking on an unorthodox monetary strategy. Because it had always avoided boxing itself in, never before had the Fed provided the financial markets with such specific guidance on the future path of interest rates.

Yet Greenspan & Co. believed they could pursue such a policy because of the unusual circumstances prevailing in the economy. Inflation was low, uncomfortably so in the minds of many at the Fed. Productivity was superstrong. And although the economy was recovering, the upswing looked fragile.

Later, once the Fed started raising rates in the summer of 2004, policymakers felt a fourth special factor allowed them to continue to steer the markets, this time to expect a series of small, "measured" rate increases. Monetary policy was extraordinarily accommodative, and interest rates had no way to go but up.


  Now, though, things look a lot different. Inflation is higher. Excluding food and energy costs, consumer prices rose at a year-over-year rate of 2.3% in January vs. a mere 1.1% in December of 2003. Productivity growth has slowed, to a 2.1% annualized increase in the fourth quarter of last year from 4% in 2003. The economy looks a lot sturdier and seems on course to grow at a 4%-plus clip in the first quarter.

And short-term interest rates are much higher after six separate quarter-point increases by the Fed. At 2.5%, the interbank federal funds rate is closing in on the 3% to 5% zone of neutrality where monetary policy is neither spurring nor hindering economic growth.

Where once the Fed feared to tred, monetary policymakers are now considering ways to back off their strategy of molly-coddling the markets. At this stage, central bankers want to carve out more flexibility for monetary policy. But as they prepare to increases rates another quarter-point, to 2.75%, on Mar. 22, officials are finding that it's not so easy to extricate themselves from their strategy of giving investors more specific language about what to expect in the future. "It's very tricky," says former Fed official Brian P. Sack, now a senior economist with consultants Macroeconomic Advisers.


  On the one hand, faced with a surprisingly strong economy and growing inflation fears in the financial markets, some Fed officials likely would prefer that the central bank scrap its statement that interest rates will go up at a "measured pace." It's not necessarily that they think the Fed needs to up the ante right away and start raising rates in half-percentage-point increments to contain inflation. It's just that they would like to have the added flexibility to do so should that prove necessary. Such a step would also serve to convince the suddenly skittish bond markets of the Fed's anti-inflation resolve.

Other Fed officials clearly are worried about junking the Fed's proclamation of "measured" rate increases and want to retain it. "My expectation is that the [Fed] will continue to remove policy accommodation in a 'measured' way," central bank Governor Ben S. Bernanke said in speech in Chicago on Mar. 8.

These officials argue that inflation is likely to stay low, despite the financial markets's heightened fears. Wage increases -- among the most important factors in determining inflation -- have been modest. While productivity growth has slowed, it's still strong by historic standards. And corporate profit margins are wide, which means companies can absorb cost increases without raising prices, especially if they're worried about losing business to competitors.


  What's more, investors are likely to narrowly interpret the Fed's scrapping of its "measured" statement as a sign that the central bank is ready to step up the pace of its rate hikes, says economist Louis Crandall of consultants Wrightson ICAP. That would give the Fed less flexibility, not more in setting policy. That's probably not the message the Fed -- even the anti-inflation hawks -- want to send right now.

What's the bottom line? Even if the Fed opts to tweak the forward-looking language in its statement on Mar. 22 -- a possibility, though not a certainty -- it will probably try to do it in a way that doesn't lead the markets into expecting a switch to half-point rate increases. That's no easy task. But it's one that the central bank set itself up for when it decided more than a year-and-a-half ago to pursue its unconventional strategy of telling -- more than just signaling -- the markets where it thinks rates should be headed.

Miller is a senior writer in BusinessWeek's Washington bureau

Edited by Beth Belton

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