Greenspan Dares to Be Cautious


By Michael Wallace Federal Reserve Chairman Alan Greenspan's semiannual testimony before the Senate on July 16 about the state of the U.S. economy was a resounding victory for those predicting that he would sit on the fence in economic and policy terms. While he remained resolute in his opinion that economic fundamentals are improving, the Fed chief refused to throw a lifeline to an unusually volatile stock market.

Clearly, Greenspan came to Capitol Hill intending to talk about corporate-governance problems, which he laid out in his typically methodical way, detailing the history and impact of recent failures and ailments. Investors looking for some sort of rescue bid from the chairman were essentially told that the Fed would remain accommodative in its monetary policy -- so long as the temporary forces inhibiting growth continued to outweigh the improving fundamentals.

FAITH IN CONSUMERS. Greenspan made it clear, however, that this was merely a holding pattern before the Fed tightens the monetary-policy reins once more, and not a step back toward a looser policy. He expects the demand side of the economy -- the consumer -- to remain resilient, while the supply side -- manufacturing -- struggles to regain its feet after the effects of inventory restocking run their course (see BW, 7/22/02, "Recovery? Manufacturers Aren't Convinced").

While Greenspan did acknowledge the lasting effects and downside risks from the reverse-wealth effect -- as consumers feel poorer in the wake of equity market declines -- he saw this largely offset by persistent strength in consumption. The apple of consumers' eyes remains the still-robust housing market, thanks to historically low mortgage rates and the availability of home-equity financing. That said, Greenspan did not anticipate any upside surprises from the housing sector, in light of its already-strong gains of the recent past.

Gazing upon the business sector, though, the Fed chief was more subdued. He repeated the mantra of the policy-setting Federal Open Market Committee: "While final demand has been increasing, the pace of forward momentum remains uncertain." Still, the Fed's updated economic outlook, via its central-tendency forecasts, was a little more bullish on the economy than it was in February.

STIFFER PENALTIES. Despite all of Greenspan's confidence in the economic fundamentals, he showed an unmistakable unease over corporate malfeasance potentially undermining the Fed's good work. He devoted more than a third of his eight-page speech to the thorny issue of corporate governance. He endorsed the broad overhaul of corporate fraud, securities, and accounting laws unanimously passed by the Senate on July 15 and expressed strong agreement with the stiffer penalties imposed for wrongdoing.

Greenspan cautioned, however, against a legislative and regulatory backlash that could burden the economy. He said that greed could not be regulated away, though some CEO incentives played a role in the debacle, including the failure to expense stock options. Long a voracious student of theories on human nature and individual character, Greenspan warned that the corporate culture molded by irresponsible CEOs was largely to blame for fraudulent behavior.

Market reaction to the testimony was mixed. Blue-chip stocks sank as Greenspan began his remarks, recovered some of their losses by early afternoon, and then resumed their slide after he concluded his testimony. After a similar see-saw advance, Treasuries slumped, and the yield curve flattened. Greenspan dismissed doomsayers on the dollar, saying foreign-exchange rate forecasting was a complex business, and the trade-weighted dollar index staged a partial rebound.

NO SURPRISES. In the final analysis, the Fed's policy outlook was little altered, though the chairman could always amend his stance in his remarks before the House on Wednesday, July 17. We at S&P MMS expect the Fed to hold interest rates where they are at least through January, 2003 -- perhaps longer, if investor confidence hasn't recovered by then.

The market seems to agree. Prices of Fed fund futures, a trading vehicle for market pros to bet on future interest rate moves, slumped on July 16, mostly in a profit-taking move, after Greenspan signaled that he would not be corralled into an imminent easing. For now and the foreseeable future, caution remains Greenspan's guide. Wallace is a senior market strategist for Standard & Poor's/MMS International


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