Fed chairman will have to tighten America's belt sooner rather than later
Larry Elliott Monday May 10, 2004 The Guardian
For the best part of 20 years, Alan Greenspan has been a symbol of the stupidity of ageism. He became chairman of the US Federal Reserve at 61, when plenty of workers have already been tossed on the scrapheap and many others are preparing to wind down for retirement. His golden years in charge of the US economy were when he was pushing 70 and he's still there aged 78. Greenspan is the doyen of central bankers, still talked about in almost reverential terms by his peers. The fact that the Fed chairman rarely gives interviews and makes public pronouncements that are to economics what Finnegan's Wake is to literature only adds to the mystique.
It is, then, with some trepidation that the question has to be asked: has Big Al finally lost the plot? At the start of last week, Greenspan presided over a meeting of the Fed which kept interest rates on hold at 1%, the level they have been pegged at for nearly a year. A statement accompanying the decision said the risks to inflation were balanced, which means the Fed thinks there is as much chance of the cost of living going up as going down. On Thursday, new joblessness claims in the US fell to their lowest level in getting on for four years, and the picture of a recovering labour market was underlined by Friday's non-farm payrolls which showed an increase of 288,000, above what had been expected. The economy is expanding at an annual rate of 4.5%, surveys of both manufacturing and the service sector are strong, the housing market is booming, inflation has started to pick up.
Hardly surprisingly, Greenspan's call on inflation is now coming under the microscope, even by those on the Keynesian left who tend to favour expansionary macroeconomic policies. "Show me something, other than computers, where the price is falling," says Dean Baker of the Centre for Economic Policy Research in Washington. Baker is right. Clearly, risks to inflation are on the upside, and massively so. The economy has been injected with a cocktail of three growth-inducing drugs - negative real interest rates, a rising budget deficit and a falling currency. Oil prices have touched $40 a barrel and the labour market is tightening. It is hard to believe that Greenspan, a junkie for economic data no matter how seemingly trivial, has not spotted all this. Rates in the US are far below a neutral level, which would probably be around 5%, yet Greenspan is in no hurry to act.
Waiting game
Last Tuesday's Fed statement did suggest that, yes, perhaps there would come a time for a bit of gradual monetary tightening but not just yet. The Bank of England has raised interest rates three times since November in an attempt to ensure that it stays on top of events, but even after Friday's strong employment data there were those predicting that Greenspan would wait until August before tweaking interest rates rather than moving at the next meeting, in June. Greenspan's argument appears to be that he wants to be sure that the recovery from the relatively mild recession of 2001 is firmly entrenched, but the evidence could hardly be any more conclusive. The risk is that the Fed is now a long way behind the curve, with all the factors in place for another period of deep instability in prospect for the world's biggest economy.
What then is Greenspan up to? There are really only three possible explanations. The first is that he believes that 1% interest rates are appropriate at a time when fiscal prudence has been thrown to the winds by George Bush's tax cuts and the extra spending needed for Iraq, when commodity prices are hardening across the globe and when the US consumer is taking advantage of cheap money to load up on debt. If that is the case, he really has lost it.
The second explanation is that Greenspan believes the US economic recovery is much less robust than the public has been led to believe, and that withdrawing monetary stimulus could bring the house of cards down. This is not a message much heard in the US (where the predominant voice is that of Wall Street economists who have a vested interest is talking up the stock market) but it is true that Greenspan solved the problems caused by the collapse of the bubble in the stock market by creating two new bubbles - in the housing and bond markets. Economist Kurt Richebächer puts it this way: "The stock market bubble of the 1920s ended with an unprecedented consumption boom, and just that has been happening again since 1997, and in particular since 2001. Since then, consumer spending has accounted for 92% of GDP growth. Yet, to keep it rising in the face of grossly lacking income growth, the Fed has invented a policy stance that has no precedent in history: boosting home prices with artificially low interest rates in order to provide rapidly growing collateral for consumer borrowing."
Richebächer's view is that Greenspan has papered over the "existing maladjustments from the boom through even bigger, new bubbles and macroeconomic maladjustments, heralding much worse to come in the future".
What next?
The key question is what happens once policymakers try to wean the US off its growth drugs. Unless Bush is prepared to push through new tax cuts - the ultimate dud cheque, given the size of the budget deficit - the boost to consumers from higher take-home pay will fade. Raising interest rates would pull the rug from under the housing market, while if the Fed's negligent approach allows inflation to pick up over the coming months watch out for a crash in the bond market. Even the tiniest threat of higher short-term rates spooked Wall Street last week: it's not hard to imagine what some aggressive tightening would do, particularly if it looked as though the Fed was struggling to catch up.
All that said, there is still enough momentum in the US economy to carry it along into next year, by which time the presidential election will be over. This is the third possible explanation for Greenspan's actions; that having been seen as a contributory factor in the downfall of one member of the Bush family, he is making sure he doesn't fluff his lines second time around. If this is the case, it doesn't say much for the independence of the Fed, and it will add to the economic problems of whoever wins in November. It's a good bet that there will be a large dollop of both monetary and fiscal belt-tightening in 2005, and Greenspan might be well advised to bow out gracefully before the brown stuff attaches itself to the fan. As Gordon Brown always says, there are only two types of finance minister: those who fail and those who get out in time. The same applies to central bankers.
larry.elliott at guardian.co.uk