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Commentary: The Fed: Too Soon For A Victory Lap?


Federal Reserve Chairman Alan Greenspan was in a self-congratulatory mood when he spoke to the annual meeting of the American Economic Assn. on Jan. 3. In a lengthy defense of his 16-year tenure atop the central bank, the grand master of money argued that the gathering recovery -- and the mildness of the recession that preceded it -- vindicated his much-maligned hands-off approach to the roaring '90s stock market. Instead of trying to rein in prices by tightening monetary policy, he allowed a bubble to build, but then cut interest rates sharply to contain the fallout once the bubble burst. "There appears to be enough evidence, at least tentatively, to conclude that our strategy of addressing the bubble's consequences rather than the bubble itself has been successful," he told the audience in San Diego.

But hold on, a coterie of Fed critics warn -- it may not be time to declare victory just yet. They argue that the Fed's continued ultra-easy monetary policy could end up hurting, rather than helping, the economy down the road if the central bank is not careful. "A 1% interest rate is an emergency rate," says former Fed economist Sherry Cooper, now global economic strategist for Toronto-based BMO Financial Group. "Yet with the economy growing at 8.2% in the third quarter, industrial production rebounding, and corporate profits surging, this is hardly an emergency."

So what are the naysayers fretting about? Some economists, including Edward E. Leamer of the University of California at Los Angeles, maintain that the Fed's superlow interest rates have led to an overhang of consumer debt and an unsustainable rise in home prices. Leamer sees a risk of a recession in 2005 as strapped consumers finally cut back on purchases of cars and homes. "The markets for both are very fragile," he says.

Others worry that the Fed could end up reigniting inflation if it keeps short-term interest rates at their current 45-year lows for too long. In fact, signs of inflationary pressures from the Fed's stimulative monetary policy and the bulging federal budget deficit are already starting to appear. Commodity prices are soaring, with crude material prices up more than 17% over the past year. The dollar is weakening, pushing up import prices. "We're seeing the beginning seeds of inflation," says Brian S. Wesbury, chief economist of investment banker Griffin, Kubik, Stephens & Thompson Inc. in Chicago.

NO SMALL RISK. The problem is that the longer the Fed waits to hike rates, the further and faster it may ultimately have to move to keep inflation down. That's no small risk: With the Fed leery of raising rates too close to the Presidential election, it has a limited window to act. If it hasn't tightened rates by August, it may put off a hike until 2005. Given that it takes up to 18 months for higher rates to have an effect on inflation, some analysts believe the Fed may be playing with fire.

Why is Greenspan smiling? He thinks the fears of the Fed's critics are overblown. True enough, consumer debt has ballooned, but that's partly because many more people own homes and have mortgages. And yes, housing prices have risen, but there is no sign of a nationwide bubble.

As for the risk of a big runup in inflation, Greenspan and his central bank colleagues just don't see it. "The recent acceleration in commodity prices...would likely only add a tenth or two to the core inflation rate," Fed Governor Ben S. Bernanke told the economists' association on Jan. 4. The same is true of the inflationary impact of the dollar. While down sharply vs. the euro, it is only off about 12% against a broad basket of currencies of trading partners, Bernanke said.

In his AEA speech, Greenspan said that monetary policy could be judged as too loose -- were it not for the risk of deflation. The rationale: While the prospect of deflation is remote and receding, the danger it would pose for the economy is too big to be ignored and far more worrisome than a small uptick in inflation from today's very low levels. Greenspan is willing to err on the side of easing policy to help make sure that the economy is well clear of the troubles of the bursting bubble. By Rich Miller


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