Greenspan tiptoes on a tightrope
Ashley Seager
Monday June 28, 2004
This week will almost certainly see the definitive end to the cheap money that refuelled the US and world economies in the dark days of the dotcom bust, September 11 and the war in Iraq.
The US federal reserve, the world's most powerful central bank, will on Wednesday finally raise interest rates for the first time in four years and by a quarter point from a 46-year low of 1%.
The move has been so widely hinted at by Fed officials in recent months that anything else would be a major surprise. Markets should be unperturbed. So far, so good.
For the past year the Fed, led by the redoubtable 78-year-old Alan Greenspan, sworn in a week ago for a fifth and final term, has sought to ensure the economy is firmly back on track after its three-year slowdown by keeping rates rock bottom. In real terms, adjusted for inflation, they are negative.
That job looks done or, possibly, as Greenspan's detractors say, overdone. Economic growth is steaming along at an annualised 4%, factory output is booming, and confidence among consumers and businesses is high.
And the recovery, long dubbed "jobless", is now generating a quarter of a million jobs a month, offering President Bush the chance to avoid becoming the first president since Herbert Hoover to preside over a net loss of jobs. Indeed, some argue that Greenspan, whose rate rises in the early 1990s have been cited as one reason George Bush Sr did not win re-election in 1992, has delayed tightening policy this time because an election is looming in November.
While Greenspan has retorted that he wanted to wait until the economy was creating plenty of jobs, there is no doubt that inflation is now rearing its ugly head. The headline measure has moved up to 3.1% from 2.1% a year ago while even core inflation, which strips out rising oil prices, is up to 2.0% from 1.1%.
The crucial question now is how the Fed weans the economy off the medicine of ultra-cheap money without causing nasty withdrawal symptoms such as a collapse in the over-heated housing market. The US economy is also carrying some other nasty imbalances apart from the the housing market. There is a record current account deficit and huge budget deficit, thanks to Bush's big tax cuts and spending on the war in Iraq.
Thus Greenspan is walking a tightrope and arguably without a safety net beneath him. Rates are clearly too low, say the critics, and have been for too long.
As the Bank of England's governor, Mervyn King, pointed out this week, rates in Britain have been rising since November and have only had to move from 3.5% to 4.5%, not far from where they probably need to be. And the economy here is only growing at an annualised rate of 2.5%, a lot slower than the US, as is inflation. In the US, Mr King said, rates will have to rise much further and faster than here. But the last time the Fed raised rates quickly, from 3% to 6% in 1994-95, financial markets suffered a meltdown, with knock-on effects on the economy.
It is clear that policy makers around the world are casting nervous glances across the sea to the US, fearful of the impact on their own economies if the Fed should mess up. Alistair Clark, a key aide to Mr King, crystalised the concerns last week: "Managing the process in a way that generates minimum disruption will call for considerable care both in determining monetary policy and in its presentation."
Small wonder, then, that Greenspan has stressed the Fed's gradualist approach and has used the word "measured" to describe the likely pace of rate rises. He has also argued that "inflationary pressures are not likely to be a serious concern in the period ahead", but that the Fed will do "what is required to fulfil our obligations to achieve the maintenance of price stability". In other words, "rates are going up slowly but we'll speed up if we have to".
A key part of controlling inflation is controlling workers' and firms' expectations about it. Give the impression that you have lost your grip on it and people demand bigger pay rises and companies raise prices. But stamp down too resolutely with rate rises and you can tip the economy off the edge.
So all eyes will be on the language the Fed uses to accompany its rate rise, particularly how the word "measured" is used, for any hint that the Fed may raise rates more quickly than markets are expecting.
For now, at least, economists think the Fed will bide its time, raising rates in quarter-point increments to 2% by the end of this year and 3% a year from now. But after that things are murkier. It is clear from statements from Fed officials that there is little agreement about how high rates may have to go to no longer stimulate the economy, known as the "neutral" rate. They have offered their own ideas in recent times, ranging anything between 3% and 5%.
"They are starting off on a journey but they don't know what the destination is," says Stephen Lewis, chief economist at Monument Securities in London. "I think they will carry on raising rates until the economy shows signs of slowing down, then they will stop."
The key lies with inflation. The gradualists on the Fed's rate-setting committee argue that the recent rise is only temporary and will pass. Oil prices appear to have stabilised below $40 a barrel and unemployment, at 5.6%, shows that the economy still has lots of slack to be used up before the labour market, in particular, starts to generate any upward pressure on wages and prices.
But the pessimists point to the fact that as inflation was very low last year, so-called "base effects" will mean some high reported numbers through the summer and autumn this year.
That could have a big upward effect on Americans' views about inflation. Figures show inflation expectations have already picked up to above 3%.
So if inflation does take off, Greenspan could well be proved to have been behind the curve. And if he has to play catch-up, talk of rates peaking in the 3%-5% range may be overoptimistic. The last peak, four years ago, took rates up to 6.5%.
Having said that, whichever candidate wins the US presidential race in November, there is likely to be a period of belttightening. Both Bush and his Democratic challenger John Kerry have promised to halve the budget deficit in the next few years.
So, just as the fiscal and monetary loosening of the early years of the new millennium have bought America, in the words of former IMF chief economist Ken Rogoff, the "best recovery money can buy", so a combined tightening may just slow things down nicely. But if things go wrong, Greenspan will go down in history as the Fed chief that lost the plot.
ashley.seager@guardian.co.uk
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