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Deconstructing Alan Greenspan

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Perhaps the most puzzling aspect of the Federal Reserve’s move to cut interest rates a half-point this week was the central bank’s conclusion that risks are “balanced” between the possibilities for renewed inflation or a further economic slowdown. If the risks truly are so finely balanced, why was it necessary to make such a dramatic move on rates?

The answer lies in understanding Fedspeak, Chairman Alan Greenspan’s fine art of describing economic conditions in a code that is left open to interpretation.

As consumer and business confidence suffer under the weight of uncertainty over a possible war with Iraq, the economy is expected to slow to a near standstill this quarter, with some analysts forecasting growth of 1 percent or less. While a double-dip recession is still considered unlikely, the odds have grown substantially in recent months.

Rising prices, meanwhile, are barely a blip on the radar screen, even for inflation-wary central bankers, who appear more worried about the lack of pricing power. When Fed policy-makers met Sept. 24, they expressed concern about the possible “emergence of appreciably lower inflation” that could make it difficult to conduct monetary policy, according to minutes released this week.

“The risks aren’t balanced,” said John Silvia,” chief economist for Wachovia Securities. “You know that, I know that and everybody out there knows that. The risks are on the downside.”

“Even the Fed does not believe its neutral policy statement,” agreed Ethan Harris, co-chief U.S. economist for Lehman Bros.

Yet if the Fed had acknowledged the downside risks to the economy in its statement Wednesday, it could have sparked fear that conditions were even worse than they are and raised expectations of another rate cut in December. By declaring the risks balanced, Greenspan has virtually eliminated any chance of another rate cut next month and offered a compromise to central bankers who might have been hesitant to cut rates a half-point from their already low levels.

“This was a way to put the focus on the immediate step, and not to give the wrong impression that they have panicked and gone too far,” said Bob DiClemente, chief U.S. economist at Salomon Smith Barney. “It may have been there was some preference for doing less. As a way to get unanimity or consensus that language is a useful tool.”

He and other analysts do not rule out further rate cuts next year if needed, particularly in the event of an external shock, possibly related to the Iraqi situation. Harris expects another quarter-point cut, probably in January. He points out that over the past decade the Fed often has “prematurely declared victory after a big policy move,” only to adjust rates again within a few months.

“They can always do whatever they want at any time, so the language doesn’t put them in a box,” DiClemente said. Still, Fed watchers could not recall a time when the Fed changed interest rates and then immediately shifted to the so-called neutral bias.

The question remains whether the Fed move will have the desired result of spurring business investment and inspiring enough consumer confidence at least to sustain spending through the important holiday retail season.

Early results were mixed, with stock prices ending the week about 2 percent below where they were when the Fed decision was announced. Yields on short-term securities rose and long-term yields fell, reflecting in part the expectation that the Fed’s next move could be a rate increase sometime in mid-2003.

The latest economic data indicate the consumer has not yet rolled over, so perhaps concern about the holiday season is overdone. Chain-store sales grew a surprising 3.1 percent in October, according to private estimates, and consumer credit grew by $10 billion in the latest month, far more than expected. Mortgage rates fell slightly in the latest week and are likely to slip further, based on this week’s bond market action, supporting continued strength in both housing sales and refinancing activity.

“I don’t think consumer spending will fall off, but auto and housing-related sales are not going to be as strong as they have been,” said Sung Won Sohn, chief economist for Wells Fargo. Indeed, car and light-truck sales plunged in October to the lowest level in four years, as a wave of buying sparked by incentives subsided. Still, consumer confidence and spending are likely to respond quickly to any improvement in the moribund labor market.

“Right now I’m more concerned about business confidence,” Sohn said. “They need to spend money and hire people.”

With the Fed likely on hold at least until late January, and the Republicans gaining controls of Congress, the economic focus will shift to Washington where many on Wall Street expect fiscal stimulus in the form of a new round of tax cuts and possibly higher spending on defense.

“I’m of the opinion that monetary policy is becoming less effective and could become impotent at some point,” Sohn said. “We really need to use a different set of tools.”