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As deflation-phobes at the Federal Reserve pressed for a further cut in interest rates over the past few months, Chairman Alan Greenspan counseled patience. He was willing to acknowledge the potential risk of a broad-based decline in prices for goods and services. But he argued that, with the war in Iraq over, the economy was poised to recover on the back of lower oil prices, a stronger stock market, and enhanced consumer confidence.
Now, though, just as the conditions for that recovery are falling into place, Greenspan is suddenly sounding like he may just agree to another rate cut after all. Speaking by satellite from Washington to top bankers meeting in Berlin on June 2, the Fed chief hinted that the central bank might reduce short-term rates further from an already rock-bottom level of 1.25% at its June 24-25 policymaking meeting to guard against further economic weakness.
So what gives? Is Greenspan throwing in the towel on a second-half recovery? Far from it. He still thinks the economy is ready to rebound. But he's disappointed at the pickup's pace so far and worried that it might not be fast enough to restore shattered corporate confidence, bring down unemployment, and, most important, dispel the danger of debilitating deflation. A Fed move now would validate the recent steep fall in long-term interest rates that has triggered a new round of mortgage refinancings and helped buttress the rising stock market.
CONSUMER FATIGUE? What's more, Greenspan suggested to the bankers, cutting rates again has little downside. After all, inflation is running at a mere 1% or so and, if anything, looks likely to fall further in the coming months because of all the slack in the economy.
For Greenspan & Co., it's not enough if growth picks up to 3% or thereabouts in the second half, from under 2% in the first. What the Fed wants is a sustained period of above-trend growth of 3.5% or more. Because productivity has stayed so strong, such supercharged growth is needed to breathe life into what the Fed chief called "an exceptionally weak labor market."
Indeed, figures due out on June 6 are expected to show that the unemployment rate ticked up to 6.1% in May, from 6% in April, as companies pared payrolls further. And as long as joblessness continues to rise, the risk remains that consumers, until now the stalwarts of the recovery, could finally cut back on their spending, throwing the economy into reverse in the process.
FIRE FIGHTING. Still, the danger of deflation is especially occupying the Fed's attention. In an unusual moment of candor about an coming monetary meeting, Greenspan let slip in his June 2 remarks that Fed policymakers would discuss the deflation risk at their next gathering. What worries the Fed, Greenspan said, isn't falling prices per se. Instead, the concern is what he called "corrosive deflation," a broad-based decline in prices that feeds on itself and brings down the stock market and the economy with it.
As he has made clear before, Greenspan thinks that the danger of deflation developing is small. But its impact on the economy is potentially so debilitating that the Fed is willing to bend over backward to avoid it. Also arguing for preemptive action is the Fed's lack of experience in handling deflation, which, after all, hasn't been an issue in the U.S. since the 1930s. "As a consequence, we need a wider firebreak, in logging and forestry terms, because we know so little about it," Greenspan said.
And it will take more than a moderate economic recovery to reduce the risk of deflation. Rapid growth is necessary to take up the slack in the economy and, in the process, reduce the pressure on companies to slash prices to stimulate demand.
Unfortunately, such a rapid revival on the growth front is so far not visible. Yes, the economy is picking up, with even hard-pressed manufacturers reporting stronger orders. But it's shaping up to be a half-speed recovery rather than the full-fledged one Greenspan would prefer. That's why the Fed chief, in his comments to the bankers on June 2, welcomed recently enacted tax cuts as fortuitous -- a shift in his stance. And that's why it's a good bet that he'll drop his opposition to another rate cut and agree to ease credit further when the Fed meets later this month.
Miller covers the Federal Reserve from BusinessWeek's Washington bureau Edited by Beth Belton
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