Greenspan's Credibility Gap


By Rich Miller These are rocky times for Federal Reserve Chairman Alan Greenspan in his relationship with the financial markets. Revered for years as a monetary maestro who could do no wrong, Greenspan now finds himself the subject of derision and doubt in the bond market. Investors, stung by the wide swings in bond prices over the past few months, blame Greenspan and the Fed for misleading the markets about the threat of deflation and the central bank's likely response to it. The result: A loss of Fed credibility that could have damaging effects on the economy.

The diminished confidence in the Fed shows up most clearly in the futures markets. Investors there have ignored statements by Greenspan and other Fed officials that short-term interest rates will remain low for a long time and instead are betting on a tightening of monetary policy next spring -- if not earlier.

"RISK-MANAGEMENT APPROACH." In his kick-off speech on Aug. 29 to the Kansas City Fed's annual monetary meeting in Jackson Hole, Wyo., Greenspan didn't directly address the market's ire over the Fed's perceived miscues. Instead, he used a broad brush to describe his own strategy of formulating monetary policy, which he dubbed a "risk-management approach." Unfortunately, while that may help increase understanding in the future, it likely will do little to improve the Fed's credibility now and relieve the upward pressure on bond yields and mortgage interest rates. Indeed, it could even make the situation worse.

Greenspan told the assembled central bankers and private economists at Jackson Hole that the economy is just too complicated for the Fed to run policy based on simple rules. Even the Fed's own complex macroeconomic computer model, with its thousands of mathematical equations, can't do justice to the economy's intricacies and continually evolving structure, he said.

So the Fed is forced to fall back on a less quantifiable, more judgmental approach to making monetary policy. "A central bank seeking to maximize its probability of achieving its goals is driven, I believe, to a risk-management approach to policy," Greenspan said. As outlined by Greenspan in his speech, such an approach involves weighing the probabilities of various economic outcomes and acting accordingly.

ECONOMIC INSURANCE. Take the Russian debt default in the fall of 1998. Even though the Fed believed that the economy could weather that crisis on its own, it cut interest rates anyway to reduce the risks in case its judgment proved wrong. And with inflation then low and likely to remain that way, it decided that the costs of taking out such an insurance policy were minimal, Greenspan explained.

The Fed chief added that this is the same approach that the Fed has employed recently in dealing with the dangers of deflation. "Federal Reserve policymakers [have adopted] policies that limit the risks of deflation even though the baseline forecasts for most conventional [macroeconomic] models would not project such an event," he said.

The problem isn't that the markets don't understand Greenspan's risk-management strategy. The difficulties have arisen perhaps because they understand it too well. If the Fed was truly following a risk-management approach to monetary policy, many market mavens say it should have cut interest rates by a half point in June, not a quarter point as it did, so as to truly mitigate the dangers of debilitating deflation.

The fact that it didn't raised questions about the Fed's intentions and, together with growing signs of economic strength, led to the nearly 1 percentage-point rise in long-term interest rates over the past 2 months.

UNCONVINCED. What's more, the markets are still not sure what the Fed's risk-driven strategy of monetary policy means for the path of short-term interest rates in the coming months. If, as Greenspan seemed to indicate in his speech, the Fed cut rates so sharply in part because of the risk of deflation, what will it do as that risk recedes and the economy expands? Fed policymakers have sought to convince the markets that they'll stand pat for quite a long while, even as the economy picks up steam. But investors are skeptical.

A lot more is at stake than just the Fed's credibility. If long-term rates rise too far, it could crimp the recovery and hold back growth next year. That's why Greenspan and the Fed need to do a better job of fleshing out just what the central bank's risk-management approach means for interest rates. Miller, who covers the Federal Reserve for BusinessWeek in Washington, is at the Fed symposium in Jackson Hole, Wyo.


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