In recent testimony before the Senate Banking Committee, Federal Reserve Chairman Alan Greenspan laid the foundation to raise interest rates before the November election. He made three central points:
- The US banking system remains strong.
- The international banking system is strong and adding more sophisticated risk management systems.
- US banks are well positioned to adjust their balance sheets to higher rates.
This is the trumpet blast heralding a shift in monetary policy that should be announced as a "tightening bias" at the May meeting of the Federal Open market Committee. Though the Dow Jones Industrial Average closed 123 points lower after his comments, the new posture is good news. According to Greenspan, there is little risk of deflation and economic growth is strong.
Good news: Corporate profits are rising; for the first time in a few years companies are enjoying modest pricing power, and jobs growth is rebounding. So why did the market drop? The real answer is that no one knows, but some factors are that the market hates surprises, shifting monetary policy is fraught with peril, and short-term markets are irrational and emotional.
It is always hard for me to understand how the market is surprised about rising rates after they have hovered at 60-year lows for a considerable period. Fed Funds last traded at these levels in 1958. Maybe it is like my grandfather dying suddenly of a heart attack at age 101. He was in great health, gave up driving at age 100, and I suppose had lived so long that some of us thought he might ever die.
The Next Worry
That the economy is recovering in an environment of tremendous liquidity presents a difficult and potentially dangerous situation economically. Near the end of the market's boom in June 1999, Greenspan was so certain that he saw the specter of inflation lurking beneath the bed that he raised short rates to 6.5 percent by June 2000. In January 2001, perhaps sensing that previous actions had gone too far, the Fed began to cut. They continued to lower rates through June 2003 to a low of 1 percent. But that wasn't enough to get the economy or markets to turn up. Fiscal stimulus in the form of tax cuts proved necessary to turn the tide.
Think of this huge liquidity as a can of gasoline used to nurture the dwindling flame of the economy. As the flame recovers and grows it spreads ever closer to the can of gas. The can has to be moved away from the flame but not so far away that it cannot be tapped if the flame begins to dwindle. Take this analogy to the extreme: if the flame reaches the can, the explosion could extinguish the flame once and for all. The Federal Reserve must be delicate and decisive in preventing the explosion.
High Inflation: Bad
A little inflation can be a good thing. Some modicum of pricing power helps profits and therefore hiring, wage increases, and business expansion.
But too much pricing power -- "demand push inflation" -- is not a good thing. This type of inflation occurred in the gasoline shortage of the 1970s when prices could be raised arbitrarily even if there was no real shortage of supply.
No one wants high inflation. With price increases small, borrowing is cheaper because interest rates are lower. Productivity improves as companies, unable to pass along costs as higher prices, are forced to operate more efficiently. Profits and earnings are viewed as being "clean" as they represent the real difference between cost of sale and final sale profit. During inflationary periods, profits are padded by the steady increase in prices that occurs during the production process.
Reluctance to raise rates could create risks. With little inflation priced in, short-term interest rates could stay low even as the recovery gets into full swing -- perhaps as low as a fed funds rate of 3 percent to 3.5 percent. That wouldn't leave much room for the Fed to cut when the next slowdown comes.
Politics
This is good news for George Bush. Greenspan is ringing the Economy-Is-Improving bell. Of the two central issues in the 2004 campaign, the Iraq war and the economy, the economy has been moving in the incumbent's favor and is now receiving some much needed advertising from a most credible source.
The Federal Reserve has a problem. It typically stays on the sidelines during election years, but the economy is picking up enough heat that the economic gas can will have to be moved before the election. August is the consensus for the first hike of this cycle. It will be followed by others. This is not a partisan move but may be viewed as such by those for whom such an interpretation is politically expedient.
The Answer
Monetary and fiscal stimulus have created excess liquidity that must be leached during an economic rebound. If it isn't drained, devastating runaway inflation is the result. There is no question but that this effort must be handled by the Fed. They need to be delicate and deliberate. And they need to act swiftly. The rear mirror data on which economists depend has been positive for some time and in an improving environment often understates the real strength of a recovery. To the Federal Reserve we say, "Courage" and "Get Moving."
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