Greenspan’s last words?

Jul 20th 2005
From The Economist Global Agenda

Alan Greenspan, the chairman of America’s Federal Reserve, has given what may be the last of his twice-yearly speeches to Congress on monetary policy before his expected retirement. Those pleading for lower interest rates—or at least an end to the rises—found that he has not gone soft in his old age

OVER the last decade, as the baby-boomers have watched retirement lurching closer, an aura of mania has hovered over the American marketplace. Telecoms were going to carry workers along the information superhighway to the land of effortless wealth, and dotcoms promised to turn the stock market into a sort of perpetual-motion money-making machine—at least until the Y2K bug brought the entire world to a crashing halt. Now those fads are regarded with (rueful) nostalgia, and Americans are ploughing their money into real estate, with expectations of recouping a modest 20% or so a year on their investment.

Despite the madness of the crowd, at least one man has remained remarkably steady: Alan Greenspan, the chairman of America’s Federal Reserve. Credited with godlike powers by the markets in the late 1990s, he has taken something of a shellacking in the press in recent years for the usual sins with which central bankers are charged: making monetary policy too easy, which causes inflation and encourages people to bury themselves in debt; or making monetary policy too tight, which throws people out of work and makes it hard for people to pay the debts they amassed when monetary policy was looser. Open a newspaper these days, and you can often find him accused of both within a few pages.

Despite entreaties from both sides, Mr Greenspan has held his ground. The Federal Reserve has been increasing interest rates at the slow, steady pace originally promised as the economy inched out of the 2000-01 recession. As he headed into his biannual testimony on monetary policy before Congress on Wednesday July 20th, all eyes were watching to see if his words would presage any wavering from this course. With Mr Greenspan expected to step down in January, two months before his 80th birthday, this may be his swan-song before the legislative body.

The dollar rose sharply ahead of Mr Greenspan’s testimony, in the expectation that he would hint at more interest-rate rises to come—as indeed he did. Even so, there are those who feel it is nearing time for Mr Greenspan to let them level off, as they approach the range which many analysts believe to be “neutral”—neither low enough to spur economic growth, nor high enough to hinder it. That level is believed to be somewhere between 3.5% and 4.5%. In recent months, the Federal Reserve has been raising interest rates in quarter-point increments, most recently to 3.25%.

Though economic growth has remained strong (especially compared with sluggish Europe), there are ample worries to fuel the case for restraint. Oil, the fuel of the world’s economy, remains expensive. And America’s job market is still surprisingly subdued considering how far the nation is into the current economic expansion. Unemployment stands at 5%, down from a high of 6.3% in June 2003, but much of the early improvement came from workers leaving the labour force, rather than job creation. Labour-force participation remains well below its 2000 peak, and payroll headcounts have only this year returned to their 2001 levels. Consumer spending remains strong, but (it is feared) increasingly dependent on housing wealth and desperate corporate measures to shake consumers loose from their hard-earned dollars—the Big Three automakers have offered their employee discounts to the entire country to move backlogs of 2005 models off the lots.

Nonetheless, even before he testified it was clear that Mr Greenspan's words would not satisfy those hoping for easier money. In a July 11th letter to Representative Jim Saxton, the chairman of Congress’s joint economic committee, the Fed chief said that the economy seemed to be coping with higher oil prices, and that the narrowing spread between short-term and long-term interest rates, which can herald a recession, should not be cause for alarm. Mr Greenspan's testimony confirmed this view. Saying that “the US economy has remained on a firm footing, and inflation continues to be well contained”, Mr Greenspan made it clear that the bank is not done yet with rate increases. Another 0.25% increase is expected in August, and rates are likely to hit 4% by the end of the year—provided the economy remains co-operatively robust.

There are worries in some quarters, however, that this is not hawkish enough. Mr Greenspan’s letter also indicated that the bank is not acting to rein in the bubble which many fear has developed in America’s housing market. Mr Greenspan has long held that interest rates are not a good tool for bursting asset-price bubbles. This position has brought him grief from critics who blame him for allowing the stock market bubble of the late 1990s to continue to inflate long after he warned of its “irrational exuberance”. There are fears that the economy has simply lurched from depending on increasing stock prices to relying on house price appreciation to fuel growth—and that the longer this goes on, the stiffer the price Americans will pay when the bubble pops.

Rational exuberance

Mr Greenspan's testimony acknowledged the fears of both sets of critics, pointing to three primary areas of uncertainty that could derail his current, favourable assessment of the economy's prospects. Unit labour costs, which have remained subdued in recent years, have turned up of late, which will put upward pressure on inflation if the trend continues. The possibility of further increases in energy prices threatens not only higher inflation but also slower economic growth, though Mr Greenspan noted that the forecast currently embedded in futures markets is for oil and gas prices to level off. And the unusual behaviour of long-term interest rates, which are currently hovering abnormally close to short-term rates, entails a current risk of excess borrowing, particularly in the housing market, and a future risk of higher rates and slower growth.

Mr Greenspan endorsed the view expressed by Ben Bernanke, the chairman of President Bush's Council of Economic Advisors, that at least part of the unusual narrowing is due to a mismatch between high levels of global savings and relatively low levels of global capital investment. With capital investment recovering in America and Japan, this problem may heal itself. But it will remain worrying until it does. As will the housing bubble: Mr Greenspan noted that, at a minimum, some local markets are distinctly frothy and a decline in prices would undoubtedly entail economic distress. However, he was careful to add that such a decline is by no means inevitable, nor sure to produce large macroeconomic effects even if it does occur.

Mr Greenspan's speech will probably reassure those who fervently hope he is steering America between the Scylla of speculation and the Charybdis of contraction. Interest rates high enough to pop a bubble could be high enough to throw the economy into a tailspin, causing more damage than they avert. Interest rates low enough to stimulate employment may also be low enough to unleash inflation, as the central bankers of the 1970s found to their dismay. So far, America seems to be muddling through. Economic growth is strong, payrolls are recovering (however slowly), and America’s monetary policy seems to be reviving the dollar from its recent lows, which should give another fillip to consumer wallets. Mr Greenspan’s powers may not be quite godlike, but many hope that he may yet have a couple miracles up his sleeve.

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