By Michael Wallace No surprises from Alan Greenspan this time around. The first phase of the Federal Reserve chairman's semiannual monetary policy testimony before the Senate Banking Committee on Feb. 16 came out pretty much as predicted. He remained largely upbeat on the economy and the outlook for inflation. And as many observers had expected, his subsequent Q&A session with lawmakers largely devolved into a referendum on Social Security reform.
It was pretty clear the Fed chief thinks the central bank still has some work to do before the normalization of monetary policy to a "neutral" stance is complete, while its confidence is growing on the health of the recovery alongside tame core inflation. The apparent absence of any obvious forward reference to a "measured" pace of rate hikes, however, suggests that Greenspan may no longer feel obligated to soft-pedal the tightening bias.
STILL ACCOMMODATIVE. Indeed, the Fed sage spelled it out accordingly: "The cumulative removal of policy accommodation to date has significantly raised measures of the real federal funds rate, but by most measures, it remains fairly low." In other words, policy still remains accommodative, and the process of normalization will continue until the Fed funds target rate, currently at 2.5%, likely enters a 3% to 5% range often regarded as neutral territory.
Greenspan was optimistic that economic fundamentals were now less fragile, and the economy had successfully navigated the pitfall of higher energy costs and other impediments over the past couple years. He was upbeat on household spending, rising home-equity wealth, and relatively relaxed credit conditions. But he did warn against complacency about speculative "excess" arising from "long periods of relative stability."
He was also encouraged that capital spending and corporate borrowing "firmed noticeably," though business reluctance to hire new workers likely stemmed from concerns about legal liabilities, rather than anxiety about the macro view.
BENIGN INFLATION VIEW. Yet the chairman appeared confident that the Fed has maintained low core inflation and kept inflation expectations "well anchored" to date. Clearly, he recognizes potential inflation hazards, but he deftly discounted each of them even as he raised them: "Despite the combination of somewhat slower growth of productivity in recent quarters, higher energy prices, and a decline in the exchange rate for the dollar, core measures of consumer prices have registered only modest increases."
He noted that core (excluding food and energy) personal consumption expenditure and consumer price indexes, for example, climbed at relatively tame annual rates of 1.25% and 2%, respectively, over the second half of last year.
The Fed's central tendency economic forecasts issued in conjunction with Greenspan's appearance underscored his upbeat assessment of growth and benign view of inflation. On real gross domestic product growth, the forecasts for 2005 range from 3.75% to 4%, compared to the July, 2004, estimates of 3.5% to 4%. The outlook on the core personal consumption expenditure price index was amended to 1.5% to 1.75%, from a previous 1.5% to 2%. The unemployment rate is seen at 5.25%, vs. the 5% to 5.25% range previously noted.
YIELD CURVE "CONUNDRUM." From the bond market's perspective, perhaps the testimony's most compelling portion was Greenspan's devotion of nearly a full page of the written report to addressing the "conundrum" of global yield curve flattening -- the shrinking spread between long- and short-term rates. He inferred that all else being equal, the flattening of the yield curve at a time of monetary policy tightening was defying "simple mathematics" in which longer-term rates typically adjust accordingly to changes in short-term rates.
Currency dealers were mostly concerned with what the chairman had to say about the current-account deficit. He largely reiterated comforting views from his Feb. 4 speech in London, although this had less lasting impact the second time around. He argued for maintaining U.S. economic and financial "flexibility" in this regard, yet he expected market mechanisms to help stabilize and ultimately decrease the current account deficit over time, especially if foreign exporters gradually cease absorbing the weaker dollar.
When at last the lawmakers got their chance to press the Fed chief on Social Security, Greenspan did acknowledge that if transition costs for a partial privatization of Social Security exceeded $2 trillion, this could be "problematic" for the bond market, though risks from a $1 trillion level would be "marginal." On another subject, he declined to be drawn into revealing when or how the Federal Open Market Committee statement would be altered to reflect more openness at the Fed, other than to say it would be obviously changed "at some point."
NO PAUSE EXPECTED. Implied rates on Fed funds futures, a trading vehicle for market pros to bet on future interest rate moves, tracked higher in the wake of Greenspan's testimony, which contained no indication of a pause in rate hikes any time soon. However, there was also no sense the Fed will quicken the pace. Consequently the futures market remains priced for quarter-point hikes in March and May, but reflects increased likelihood of another quarter-point hike at the June meeting, which would leave the Fed funds rate at 3.25%.
Markets will tune in again on Feb. 17 for a reprise of the chairman's testimony before the House. And while Greenspan is unlikely to drop any bombshells, Wall Street will remain all ears nonetheless. Wallace is global investment strategist for Action Economics