The shift in the zeitgeist at the Fed has been nothing short of dramatic. Back on May 6th, Fed chairman Alan Greenspan brought down the curtain - at least temporarily - on the new economic paradigm he had been more than casually endorsing. At the end of a week that saw nearly every voting member of the Fed's policy-making panel tossing dovish garlands in the air, Greenspan abruptly flashed his talons and waxed bearish. The Fed chairman even questioned how much longer the economy could enjoy the ample benefits of productivity gains, a disinflationary factor he had frequently touted.
Since that day in May three fortnights back, virtually every piece of economic news has been viewed through the prism of a suddenly hostile Fed. The Greek chorus of Fed governors and regional bank presidents whose comments appear in the press several times a week also picked up the dirge, while Fed Vice Chairman Alice Rivlin, the only woman on the FOMC, and the most pronounced dove in the coop, flew off to greener pastures in private enterprise. (The Fed could use more women on its policy-making panel; they appear more in touch with the prevailing economic conditions than most of the menŠRemember Martha Seger? She was the only one who got the last recession right.)
So, the operative question is: What got into Greenspan? What transformed him, seemingly in a flash, from a trail-blazing new age thinker into a sclerotic sadomonetarist, suffering delusions of runaway inflation?
Greenspan actually tipped his hand at an award ceremony sponsored by the National Retail Foundation back on May 24th. At that poorly covered event, Greenspan counseled that a substantial part of the wealth effect was a consequence of the capital gains realized by consumers selling their homes. "The home sales market is a critical factor of what's going on in retail sales." Greenspan said. Combined with the torrid bull market in equities, these income gains have been a driving force behind the soaring pace of consumer purchases, a development that has definitely seized a hold of Greenspan by the short hairs.
While the Fed chairman and his cohorts at the Fed constantly warn about the inevitability of wage inflation should economic growth continue at its current pace, GDP has advanced at a 4% clip for the past three years while just about every measure of inflation extant is much lower than it was back then.
That's particularly true when it comes to wage inflation, which has been retreating even as the unemployment rate has tumbled to a 30-year low. Besides, the pace of job creation has also slackened appreciably this year, and the latest reading on inflation shows that overall consumer prices were flat last month, while the core rate, which excludes food and energy, is down to its lowest level in three decades.
But it isn't headline inflation that has the Fed worried. Hell, that choir of Cassandras has been caterwauling about its imminent appearance for the past several years while economic growth expanded at nearly double what the Fed had arbitrarily determined was the "sustainable" pace. In remarks made this week before Congress, Greenspan spoke of the need to pre-emptive, declared that labor productivity isn't growing fast enough to meet the increased demand for workers, and again stressed that the propensity to spend was being spurred by the big rise in equity and home prices. He reckoned that the capital gains enjoyed in those markets by consumers probably accounted for 1% of the 4% GDP growth rate for the past three years.
The bond market, which had been trading with a brown helmet for the past six weeks, staged a hearty rally, sending yields down below 6% again. Why would bond prices surge when the Fed chairman strongly hinted that the FOMC would raise short-term rates by 25 basis points at the end of the month? Because the feeling is that's as far as Greenspan & Co. will go. Indeed, a handful of analysts even think the Fed will defer tightening until a later date.
I don't think so, on either count. Since it's the wealth effect that's got the chairman so exercised, since he has sporadically ridden this hobby horse since his irrational exuberance remark in December of 1996, he is unlikely to relent until GDP growth slows to 3% and asset prices stabilize. Raising rates by 25 basis points on June 30 and then immediately declaring a return to a neutral bias (as most folks now believe) would be akin to inviting the equity market to ascend to new heights.
Forget economics and stochastics for a moment and consider this: The Fed is a hidebound, conservative institution accustomed to moving rather cautiously because of all the power it wields. An entity like that doesn't move from a neutral bias to a tightening bias and back again in a matter of weeks. Building a consensus among the voting members with little or no dissent and then acting on it is a lot like an aircraft carrier negotiating a U-turn in the Hudson River.
Look, I think bonds represent good value given the current level of inflation and where it is likely to remain, thanks to things like the Internet. But the man in charge has just changed the rules. He's concerned that the era of runaway asset prices will end in a brutal denouement, particularly now that it seems to be spreading to residential real estate.
"Even if this period of rapid expansion of capital gains comes to an end shortly, there remains a substantial amount in the pipeline to support outsized increases in consumption for many months into the future," Greenspan told the Joint Economic Committee last week. "Of course," he added, "a dramatic contraction in equity market prices would greatly reduce this backlog of extra spending."