Greenspan's growing dilemma
FTs Gerard Baker explains why the US Federal Reserve has opted for a market-driven approach and considers the risks involved - 9 Apr 2000

For a year now, Alan Greenspan and his co-pilots at the Federal Reserve have been trying to bring the high-flying US economy in for a soft landing. On the evidence so far, they should have had their pilots' licences revoked some time ago.

In spite of the Fed's five quarter-point increases in short-term interest rates in nine months and repeated warnings about the unsustainable pace of growth, the economy continues on a skyward trajectory that has taken it into its fifth consecutive year of growth of about 4 per cent or higher.

Indeed, the pace of expansion has actually accelerated since the central bank began trying to slow the economy's engines with rate increases last June. In the final three months of last year output grew at an annual rate of 7.3 per cent, the fastest in a decade. When figures for the first quarter of this year are published in two weeks, they are expected to show barely a hint of a deceleration, with growth likely to be in the range of 5 to 6 per cent.

It is now clear that at least part of this extraordinary performance is the result of a real change in the fundamentals of the US economy.

Mr Greenspan was one of the first to identify the acceleration of productivity growth that started four years ago as the economy began to benefit from rapid technological progress and large investments in capital equipment. This radical change has probably raised the US's long-term potential growth rate from the old 2.5 per cent to 3.5 per cent or even higher.

But even the Fed chairman acknowledges that the current explosive pace of demand growth is too fast, straining the capacity of the economy to supply it.

Although there remains scant sign of inflation, other evidence of that strain is mounting: a shortage of labour with an unemployment rate of 4.1 per cent; emerging signs of pressure on wages - hourly earnings rose at an annual rate of 4.8 per cent in the first three months of the year; and a current account deficit that grows larger every month as more of the demand is met from overseas.

Yet despite these signs the central bank's policymakers, puzzlingly to some, continue to adopt a steady as she goes monetary policy. While they have raised interest rates five times since last June, they have shown much less restraint in the face of apparently unsustainable demand growth than they have in previous similar periods.

The last time the Fed tightened policy over a period of several months to slow a runaway economy was between February 1994 and February 1995. Then, it raised rates by 300 basis points in a year, from 3 per cent to 6 per cent. And that occurred, not in gradual step-moves, but with some increases of 50 basis points and even one of 75.

The previous tightening phase, from March 1988 to February 1989, took short-term rates up 325 basis points in less than a year from 6.5 per cent to 9.75 per cent .

This time, the short-term increases have totalled only 125 basis points, during roughly the same period and the approach has been cautious - a quarter point at a time.

"There's a danger the Fed has got behind the curve this time," says Sung Won Sohn, chief economist at Wells Fargo Bank. "There's evidence its policy has been somewhat ineffective."

In recent weeks debate within the Fed has echoed these criticisms. At the February 2 meeting of the policymaking open market committee, a sizeable minority favoured a more aggressive approach to reining in demand - a 50 basis-point increase.

But so far Mr Greenspan has resisted such calls. Why is he keen to proceed so warily in the face of evidence of what he describes as growing imbalances?

The key difference this time, he says, is a much greater degree of uncertainty about what really is the new sustainable pace of growth.

The productivity acceleration shows no sign of abating, and there is still no obvious evidence of inflationary pressure. For the Fed to make firm judgments about what is the appropriate overall rate of expansion to aim for is probably folly, the Fed chairman argues. Instead, he says, the proper strategy is a market-driven one.

As well as raising the long-term potential growth rate, the improvement in productivity increases real interest rates. The higher rate of return on US assets attainable as a result of improved profitability requires a higher level of savings to fund the additional investment. Other things being equal, that should result in an increase in the real interest rate, until the economy returns to equilibrium at the new, faster growth rate.

While this process continues, the central bank has much less certainty about the appropriate level of interest rates than in periods of steady growth. Instead, the Fed's job is to make a judgment about whether financial market conditions are moving at the right pace to achieve economic equilibrium.

Sure enough, long-term interest rates in the US have moved steadily higher in recent years. Top-rated inflation-adjusted corporate bond yields have moved from about 4 per cent in the second half of 1996 to over 5 per cent this month. The Fed has pushed up short-term rates in line.

"The Federal Reserve has responded to the balance of market forces by gradually raising the federal funds rate over the past year. Certainly, to have done otherwise - to have held the federal funds rate at last year's level even as credit demands and market interest rates rose - would have required an inappropriately inflationary expansion of liquidity," Mr Greenspan said last week.

If the market has indeed got it right, the economy should eventually slow to a sustainable pace of growth as the higher interest rates bite further into demand.

But there are risks with this market-driven approach. First, working out what exactly are current long-term interest rates is complicated by an unusual factor at present - the market in government debt. Usually the benchmark for all long-term market interest rates, the yields on longer-dated US treasury bonds have dropped sharply in recent weeks. The reason is the large and growing fiscal surplus. As the government begins paying down its debt this year and over the next several years, the pool of Treasury bonds will dry up. In anticipation of this diminishing supply, investors have been buying treasury bonds and the yield has fallen.

Since these yields are an important component of broader financial market conditions, they are offsetting somewhat the higher federal funds rate and corporate bond yields.

Second, there is the danger that this dual market-Fed approach becomes unintentionally mutually self-defeating.

Also affecting the overall pace of demand growth in the economy at present is the equity market. Higher stock prices feed through into stronger consumer demand.

The problem is that, while Mr Greenspan is relying on market mechanisms to slow the economy, the market participants themselves are looking expectantly to the apparently omnipotent Fed chairman.

Every time the Fed raises short-term interest rates, there is an almost palpable sense of relief on Wall Street that the central bank has somehow "got the economy under control". The effect is higher share prices and lower market interest rates, a distortion of the market-driven process that should be tightening financial conditions.

This combination of factors means overall financial conditions in the US have actually remained broadly accommodative, despite the Fed's moves. According to William Dudley, chief US economist at Goldman Sachs: "More needs to be done if the economy is to slow to anything like the pace the Fed would like."

Mr Greenspan almost certainly will keep short-term interest rates rising. The hope is that soon the markets and the Fed between them will find the appropriate level of financial restraint in these unconventional times.

But in a period of such uncertainty about economic fundamentals the chances that they may not reach that level soon enough must be high. Then it would be the central bank that would have to lead the way in a much more aggressive attempt to restore old-fashioned equilibrium to the New Economy.

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