May 13, 2005

Greenspan has had leveling effect at the Fed

By James W. Coons

Alan Greenspan is almost finished with the final episode of rising rates in his career as chairman of the Federal Reserve Board. Although the final phase and its aftereffects have yet to play out, the message of most major indicators is that the Fed will engineer another soft landing. That is, it will avoid a destabilizing rise in inflation without precipitating an economic recession.

Greenspan’s term expires at the end of January. As detailed in a recent paper by Lee Hoskins, former president of the Cleveland Fed bank, Greenspan’s record stands out among his predecessors. The average inflation rate during Greenspan’s tenure was bested only by Fed chairman William McChesney Martin during the 1950s and 1960s.

Both of those preconditions are close to being met.

The latest and last interest-rate campaign of Greenspan’s career is proceeding well, too. A year ago, when the Fed’s target interest rate stood at a 40-plus-year low of 1 percent, I wrote that the Fed was about to start raising rates, and would do so by more than widely expected. The subsequent tripling in short-term interest rates to 3 percent was the largest percentage rise during a year’s time in more than 40 years.

Predictably, the economy now shows signs of slowing. Growth in real gross domestic product has slowed from its peak of 5 percent during the year ending in the first quarter of 2004 to 3.6 percent during the most recent four quarters. Growth in the quarter just passed was the slowest in two years.

Some observers have worried aloud that the economy is headed for a recession. While a real slowdown is at hand, reliable signs of impending recession are notably absent.

The past offers some guidance about the timing of the first rate increase.

Every recession has been preceded or accompanied by a rise in short-term interest rates above long-term rates — a so-called inverted-yield curve. This spread has narrowed quite a bit in the past year but remains at a level consistent with continued, if somewhat slower, economic expansion.

In addition, the weekly leading economic index from the Economic Cycle Research Institute is already pointing up again, after correctly signaling the unfolding slowdown late last year.

And while hiring is not what most of us would like to see, the tone of labor markets is that of an economy still in expansion mode. Recent weakness in retail sales, factory orders and industrial production is a view of healthy but tamer growth from the economy’s rearview mirror, not the image of recession on the horizon.

In response to the impending slowdown, the Fed will raise its target interest rate by one or two more quarter-point steps and then pause. My calculations indicate that the equilibrium rate — the level consistent with stable inflation and a growing economy — is in this 3 percent to 3.5 percent range.

When Greenspan’s term ends, inflation and unemployment will be lower than when he took over in the summer of 1987. Interest rates, short and long, will be much lower, stock prices will be three to four times higher, and the economy will be expanding.

Some people might think they could have navigated the economy along a smoother course during the past 17 years. Let’s just hope the next Fed chairman comes close to the record of the current one.

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