Did Fed Hit the Brakes Too Hard, Too Late?

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Did Fed Hit the Brakes Too Hard, Too Late?

Greenspan Defends Policy Against a Chorus of Criticism

By John M. Berry Washington Post Staff Writer Sunday, April 22, 2001; Page H01

Federal Reserve officials are no strangers to criticism. They've heard all the barbed complaints about how the central bank takes away the punch bowl just as the party gets going, and thousands of home builders once sent then-chairman Paul A. Volcker short pieces of lumber to protest the impact of high interest rates on their industry.

In more recent months, as the economy has stalled and the stock market has tumbled, letters have poured in to the Fed from individuals complaining bitterly that the central bank's actions over the past two years have ruined their retirements by driving down share prices. And even though the Fed has aggressively cut interest rates since the beginning of the year, many economists, politicians and business executives are complaining that it waited too long to begin lowering rates and that they are still too high.

Until parts of the stock market began to head south a year ago, Chairman Alan Greenspan and other Fed officials were being hailed as geniuses. The economic expansion that began in early 1991 had become the longest in American history, and in an unusual twist, non-inflationary growth had accelerated as the expansion aged. The growth of productivity -- the amount of goods and services produced for each hour worked -- appeared to have shifted into a higher gear, raising U.S. living standards in the process.

And the nation's unemployment rate was down to nearly 4 percent, a rate previously believed possible only in a world of increasing inflation. And that low rate meant that many Americans with fewer skills and low incomes were able to find jobs where none had been available before.

Then things began to sour.

The major stock indexes began slipping, and the nation's economic growth fell suddenly and sharply late last year to a 1 percent annual rate. It apparently hasn't done much better since.

While the Fed clearly sought to slow the nation's economic growth rate from an unsustainably high level, it clearly did not intend to cause growth to slow so much so fast, braking the economy to the point of possible recession.

All of which has prompted plenty of spirited second-guessing.

Too Slow to Act? Some economists and Wall Street analysts argue that the Fed contributed to the overheating of the economy by leaving interest rates too low for too long after the autumn of 1998, when financial markets seized up amid financial crises in Russia and Asia. Fed policymakers quickly lowered their target for overnight interest rates by three-quarters of a percentage point, to 4.75 percent, and left it there until June 1999.

Before that worldwide market spasm, the Fed had been on the verge of raising rates because of fears that heady U.S. growth could spur inflation. These critics say the Fed should have started raising rates months before mid-1999, when it began lifting the target in a series of steps over the following year, to 6.5 percent by May 2000.

Once the Fed began raising rates, numerous other critics argued -- as some are still doing -- that higher rates weren't needed because inflation wasn't a problem. Still another group agrees that higher rates were called for but that the Fed overdid it, particularly with its final half-percentage-point increase last May. Some complain the Fed responded too slowly to signs of trouble by waiting until January of this year to begin cutting rates again, even though it has lowered the target to 4.5 percent since then.

Rising Criticism Then there are those, like economist Stephen Roach of Morgan Stanley Dean Witter & Co., who believe Greenspan helped create some of the excesses of 1999 by stressing the glories of investment in high-tech equipment that could raise corporate profits and justify higher stock prices.

"By championing the brilliance of the new economy, Alan Greenspan joined with the . . . crowd in tacitly encouraging businesses and consumers to do the same. And they did," Roach told his firm's clients last week. "Companies became convinced that open-ended technology spending was the source of hyper-growth in both productivity and earnings.

"The financial bubble . . . truly infected the real economy. And the Fed did nothing to stop it," Roach said.

With U.S. economic growth limping along, unemployment rising, corporate profits falling and most stock prices well off their highs of a year ago, criticism is hardly surprising. But Greenspan and his Fed colleagues are unrepentant. They argue that in the summer of 1999 they had no choice but to clamp down on an economy gripped by a feverish boom.

Furthermore, some of the officials note, a large portion of the sharp run-up in stock prices, particularly for Internet and other high-tech companies, occurred months after the red flags of rising interest rates were flying. For instance, the tech-heavy Nasdaq composite index essentially doubled between the end of June 1999, when the Fed started to raise rates, and March 2000, when the index peaked.

Boom-Bust Issues To some Fed officials, the investor behavior that relentlessly drove the Nasdaq ever higher in the face of rising interest rates is a prime example of the overheated nature of the U.S. economic environment that Fed officials felt they had to address. Left alone, the boom eventually would have turned into a bigger bust, with potentially far more serious consequences for the economy than those experienced so far, the officials say.

Not so, complains Richard M. Salsman, president of InterMarket Forecasting of Cambridge, Mass., who says the Fed "responded to prosperity by punishing it."

"Had Fed officials sat still," he said, "we'd still be enjoying solid growth with low inflation and rising stock prices."

Early last month at a House Budget Committee hearing, Rep. Gil Gutknecht (R-Minn.) more gently chided Greenspan, "Do you think that perhaps the Fed waited a little long to lower interest rates?"

"No," Greenspan replied. His explanation of that answer to Gutknecht and his comments elsewhere add up to the following:

Greenspan's Case From the beginning of 1999 through last spring, the economy truly boomed. Consumer spending and business investment in new plants and equipment were increasing so fast that the economy grew in the second half of 1999 at a phenomenal 7 percent annual rate after adjustment for inflation. With the unemployment rate already falling toward 4 percent and business investment outstripping the amount of funds available to finance it, Fed officials were convinced that such unchecked growth would eventually lead to an inflation-induced bust.

One key piece of evidence of strain cited by the officials was the fact that long-term interest rates were already rising substantially before the Fed began to raise the short-term rates over which it has some control.

"The effect of that [surge in investment] was to put very significant [upward] pressure on real long-term interest rates, corporate interest rates," the Fed chairman told Gutknecht.

Under such circumstances, Greenspan said, the only way the Fed could have held down short-term rates was through "accelerating money-supply growth" -- that is, by pumping ever-greater amounts of money into an already overheating economy. Had the Fed chosen to do that, "we would have had a highly buoyant economy with rapidly increasing imbalances" between supply and demand both in financial markets and the real economy, he said.

If the Fed had kept short-term rates low, the country "conceivably" would have a higher level of economic activity now than it does, Greenspan continued, but that would have created "far greater imbalances" in the economy and eventually "a far greater correction than we're now undergoing."

And Greenspan concluded: "In my judgment, and the judgment of my colleagues, had we moved sooner [to lower rates], we would have threatened that adjustment process. It is a very difficult judgment to make, but in retrospect, I see nothing that we did which strikes me as inappropriate, as far as policy was concerned."

So far the "adjustment process" has meant slower growth of consumer spending; a slowly rising jobless rate with tens of thousands of layoffs, particularly at manufacturing firms; roughly a 10 percent drop in corporate earnings; and steep declines in business spending on new equipment.

Stock Questions The greatest source of criticism, however, has focused on what some regard as the Fed's assault on the stock market. Greenspan and other Fed officials have gone to great lengths to try to convince everyone that they are not in the business of targeting a particular level of stock prices. Some analysts believe that the Fed's half-point rate cut Wednesday was timed to occur when stock prices were already rising so that no one could conclude the central bank was trying to put a floor under the market.

Of course, rising interest rates usually do depress stock prices, and in 1999 Fed officials made no bones about their concern that big market gains, by adding to household wealth, were giving an unwelcome boost to consumer spending in a booming economy.

Certainly all of the major stock indexes are well below the peaks of a year ago. But the indexes are not down as much as one might think compared with where they were June 30, 1999, when the Fed began raising rates: At Friday's close, the Nasdaq was down 18 percent, but the Standard & Poor's 500-stock index was off only 7.8 percent and the broadest available index, the Wilshire 5000, was virtually unchanged, down just 0.5 percent. The Dow Jones industrial average is 6.9 percent higher.

Some economists scoff at the notion that it was Fed policy changes that caused parts of the stock market to fall so sharply over the past year. Interest rate policy is only one of a host of factors influencing the U.S. economy and its financial markets, they say.

"The truth is that we never know why these bubbles burst," said Princeton University economist Alan Blinder, a former Fed vice chairman. "But bubbles always do burst. Sometimes some not-crucial event can cause a bubble to burst and then it feeds on itself. Take Wile E. Coyote [in the Road Runner cartoons]. Why did he fall at just that time? Maybe he looked down and heard Alan Greenspan's voice."

"The Nasdaq fell 60 percent from the peak. There's no way you can get that from interest rates. Higher interest rates should reduce stock prices on a fundamental basis, but that can't come anywhere near explaining the market decline and the timing puzzle" of the bubble still inflating after rates began to rise, Blinder said.

With the benefit of hindsight, one can argue that the Fed should not have raised rates as much as it did, Blinder agreed.

"But they stopped in May 2000, which was pretty early," he said. "It was not obvious in May of 2000 that the second half of 2000 and the first half of 2001 were going to look as they have turned out" with such a sharp slowing of economic growth. Moreover, even as late as November, "the economy was still looking very strong but the Fed was holding its fire" on further rate increases.

"The criticism that the Fed overstayed its tightening, while true, is very much Monday-morning quarterbacking," he concluded.

Faulty Forecasts Blinder's comments highlight one of the Fed's frequent frustrations: Even significant shifts in the course of the economy take time to show up in the statistics. As late as mid-November, Clinton administration economists agreed on a short-term economic forecast covering the end of last year and 2001 and 2002 that failed to pick up the sharp weakening of the economy happening at that moment. Few private forecasters did either.

In addition, Fed officials, and many other forecasters, had been surprised in previous years when growth started to slow, only to pick up again in a burst of renewed activity.

"We've got a slowdown, and a lot of people are quite nervous," Fed governor Edward M. Kelley Jr. said in an interview at the end of November. "That's quite predictable. . . . But it's far too early to make a judgment on where the slowdown might stop. If we had a touch-and-go and went back up to high rates of growth, that would be dangerous."

Other officials feared that a rush to cut rates might encourage businesses and investors to think the necessary slowdown was never really going to come.

Brookings Institution economist Charles L. Schultze, who has been both a government policymaker and an observer of the process for many years, said Fed critics should take a step back and review not just the past few months but also the past few years.

"So much of the criticism is from hindsight, and it misses some points," Schultze said. "We didn't know it, but the world was changing in the late '90s so that we could get to 4 percent unemployment and 2 percent inflation. But the Fed was probing as it went, and there isn't any other central bank in the world that would have had that much moxie. Greenspan handled it awfully well."

The fact that the Fed earlier had established its credibility as an inflation fighter helped, "but a lot more was going on," such as the increase in investment and productivity growth, Schultze said.

"In 1994-95, the Fed also pushed rates up a lot, and it was true that first half of 1995 growth was only about 1 percent, but then it picked up again. Greenspan handled it right and kept the economy on an even keel.

"Now people are saying that he overdid the ease in 1998 . . ., but rates on neither corporate bonds nor mortgages came down a lot. It was not as if he gave us a period of low interest rates across the board," only lower short-term rates, he said.

"Finally, in the 10th year of recovery, you got this wild behavior by the Nasdaq and the Fed had to navigate its way through it. And except for the stock market, after 10 years of expansion and tight labor markets and all that, we don't seem to have a whole lot of financial excesses. It isn't like 1988-89," when the commercial real estate market was collapsing and taking major financial institutions with it.

"I don't want to be a Pollyanna, because there are problems in this transition," Schultze concluded. "But the problems are not really terrible. It is hard to sort out who gets credit, but Greenspan certainly should not get any blame on it."

The R-Word Meanwhile, the Fed has cut rates this year in its most aggressive manner since the second half of 1982 when the economy was in the depths of the worst recession since the Great Depression. Furthermore, Fed policymakers indicated more cuts are likely, including either a quarter- or a half-point cut at their next meeting, May 15.

"Right now we're worried about whether we're on the edge of something that starts with R, which I can't under these circumstances name," Robert McTeer, president of the Dallas Federal Reserve Bank, said in a speech Friday, alluding to the possibility of a recession. "We've got to put our concerns about inflation on the back burner and save the economy from the R-word."

A day earlier, Fed Vice Chairman Roger Ferguson sounded a similar note, though in more moderate tones.

"I think it's too early to have a strong conviction that the economy is reaching the end of this period of quite slow growth," Ferguson said. Just how low interest rates will have to go to spark "a return to healthy growth in spending remains an open question," he said.

Bruce Steinberg, chief economist at Merrill Lynch & Co., agreed with the two Fed officials' implicit point that rates need to go lower in coming months. If the Fed does continue cutting, he predicted, economic growth will pick up noticeably by the fourth quarter.

As for stocks, Steinberg pointed to history. Over the past 43 years, the Fed has cut rates as much as it has this year on 10 occasions. In each case, stock prices have been higher a year later. The increases have ranged from a meager 4.3 percent in 1968 to 57 percent in 1983, with an average of 25 percent.

© 2001 The Washington Post Company

http://washingtonpost.com/ac2/wp-dyn/A47160-2001Apr21?language=printer

-- Martin Thompson (mthom1927@aol.com), April 22, 2001


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