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Misreading the Fed

Alan Greenspan isn't likely to play politics with interest rates.

12:00 AM, Apr 27, 2004 • By IRWIN M. STELZER
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IF ANALYSTS AND INVESTORS would listen to Federal Reserve Board chairman Alan Greenspan with a degree of precision equal to that which he employs when he speaks, the world of financial markets would be a calmer place. Those who reacted in mild panic to last week's testimony just weren't listening closely.

Suppose, just suppose, that everyone was paying attention when the Fed chairman told congress, "Some of the strains that accompanied the difficult business environment of the past several years apparently still linger. . . . Many managers continue to exhibit an unusual reluctance to . . . [add] to their capital stock. . . . Business fixed and inventory investment . . . have risen only moderately."

Greenspan was also less than glowing in his report on the labor market. "Cautious behavior has also been evident in the hiring decisions of U.S. firms. . . . [They are] restricting their hiring. . . . The average duration of unemployment increased. The increase in real hourly compensation was quite modest" between late 2001 and the fourth quarter of 2003.

Most important, "Still-significant productivity growth and a sizable margin of underutilized resources, to date, have checked any sustained acceleration of the general price level and should continue to do so for a time." Hardly the words of a central banker with his finger on the panic button. Besides, having admitted that in the past the Fed raised interest rates too rapidly, Greenspan is not likely to throw financial markets into turmoil by repeating that error.

None of this means that the Fed will hold rates at current levels forever. That was never in the cards. But don't pay any attention to pundits who say that Greenspan and his monetary policy committee colleagues will time any change to suit one or another of the presidential candidates. No one would accuse the chairman of being insensitive to the impact of his statements and actions on the ever-nervous politicians in the White House and in Congress. But being aware of the political implications of one's policies is not the same thing as tailoring those policies to suit some politician. Remember: Republicans who praised Greenspan's wisdom when he supported tax cuts, denounced him as lacking in financial nous when he later expressed unhappiness with large, sustained budget deficits.

So ignore talk that the timing of any change in interest rates will depend on the presidential election cycle. If Greenspan were to raise rates by some tiny amount this summer, the effect on the economy would not be felt until long after voters had made their choice in November. The current President Bush might be slightly unhappy, but remember that Greenspan didn't hesitate to make Bush the elder unhappy with his monetary policy, which some say prolonged a mild recession and cost the president's father the 1992 election.

WHAT WILL DETERMINE the Fed's action is what is going on in the economy. There is no question that commodity prices are rising. The Economist's index of those prices is up by almost 60 percent in the past 2-1/2 years, and continued demand from China, a recovering Japan, and a growing United States suggest that price pressures will continue. House prices jumped almost 8 percent in 2002 and more than 8 percent in 2003--and remain strong. The costs of medical care and education are rising at double-digit rates. Crude oil and gasoline prices increases dominate daily discussions on cable channels and in the popular press.

Moreover, Greenspan says he sees a return of pricing power, which should permit firms to pass on some increases, something they have been unable to do in the past. And he sees renewed strength in the economy, which is why he is reminding one and all that some day rates will have to go up.

But not by much and not necessarily very soon. Commodities account for only 20 percent of the costs of American manufacturers, with labor costs making up the bulk of the rest. And, thanks to continued gains in productivity, Greenspan told Congress, "those costs have yet to post a decisive upturn. Even if they do, the current high level of profit margins suggests that firms may come under competitive pressure to absorb some acceleration in labor costs." Of course, if compensation begins to outstrip productivity gains by a substantial margin, unit labor costs will accelerate, inflation might rise, and the Fed will have to act.