"one cannot help wondering whether the Fed knows something the rest of us do not about financial fragility in America. " Jan 4th 2001 >From print edition ALAN GREENSPAN, chairman of Americas Federal Reserve, is not a central banker who makes a habit of surprising the financial markets. He prefers to give Wall Street what it wants and, as a rule, to deliver roughly when it expects. Yet on January 3rd, he sprang on the markets a cut in interest rates of half a point, rather than the customary tweak (be it up or down) of a quarter-point, and moreover did it without waiting for the next scheduled meeting of the Feds policy-making committee. This was a more dramatic easing of policy than the Feds first response to the Russian debt debacle and the threatened collapse of Long-Term Capital Management in 1998, a financial crisis that Bill Clinton described at the time as the worst for 50 years. The markets, given more, and sooner, than they had any right or reason to expect, were surprised all right. That is putting it mildly. Initially, at least, they greeted the news rapturously. The Dow Jones Industrial Average soared. The tech-heavy Nasdaq went crazy even by its own demanding standards, surging to a gain of 14%, the biggest since the market was established 30 years ago. So much for promoting financial stability. What on earth was Mr Greenspan up to? It would be interesting to know. On the basis of published information, the move is puzzling. It looks hasty, even panicky. Yes, Americas economy is clearly slowing. But it is supposed to be. As Mr Greenspan has been at pains to explain, if growth had failed to moderate from its earlier torrid pace, inflation would have continued to rise, and probably at an accelerating rate. The labour market is still tight; other inflationary pressures have yet to abate. That is why the Feds avowed aim has been to slow the economy. Does the evidence therefore suggest that the slowdown so far is much too abrupt? Not really, not yet. In December, admittedly, consumer confidence fell to its lowest for two years and retail sales were much weaker than expected. Unemployment insurance claims have been rising rapidly. Car sales are falling. And inventories are building up; by historical standards they are still quite low, but if the accumulation continues it will eventually force producers to curb production. Yet numbers of this sort are not inconsistent with a soft landingthe measured slowdown in growth in the overheated economy that the Fed has been trying to engineer. Was Mr Greenspan swayed then by new figures published the day before the Fed cut rates? These showed that manufacturing activity, as surveyed by the National Association of Purchasing Management, fell much more sharply than expected in December, to its lowest since April 1991, the end of the previous recession. Manufacturing accounts for only one-fifth of Americas GDP, but it remains an important economic gauge. Taking this together with the other new data, the risk of recession in America has clearly increased. But the Feds sudden cut is still puzzling. Why not wait until the next planned meeting of the Federal Open Market Committee at the end of this month? By then, a good deal more informationincluding Decembers employment data (to be published on January 5th) and fourth-quarter GDP figureswill be available. If nothing else, a cut announced at the time of the FOMC meeting would have seemed calmer and more orderly. In central banking, such things really countas Mr Greenspan is normally well aware. A shock which blasts Americas stockmarkets back upwards, which may encourage investors to believe that the Fed will protect them from risk even if it means keeping demand in the economy growing faster than supply, not merely delays the necessary economic adjustment, it runs the clear risk of worsening the existing financial stresses. Later, when adjustment can be delayed no longer, the jolt is all the more shattering. This is the answer to those who would say, If a recession seems possible, err on the side of too much stimulus. Erring on the side of too much stimulus carries with it not just the danger of higher inflation, but alsomore seriouslythe risk of a worse recession down the road. Stresses and strains Perhaps the Fed is worried about the financial markets in their own right. On the eve of this cut, Nasdaq was down 55% from its peak last year. This has hurt a lot of investors. On the other hand, the broader market had fallen much less, and anyway it would be plain wrong to cut interest rates in order to push tech-stock valuations, many of which are still too high, back up. Keeping a bubble inflated is hardly a job for monetary policy. Elsewhere in the financial system, the creaking noises are getting louder. Credit markets are drying up, as investors flee risk, making it harder and more expensive for many firms to borrow. Spreads between junk bonds and risk-free Treasury bonds have increased to their widest since the 1991 recession, wider even than in 1998, circa LTCM. The market for initial public offerings has more or less closed, and banks have tightened their lending standards to firms as past loans have begun to turn bad. All this is worryingbut these are exactly the sorts of stresses that will be worsened, except in the short term, by a panicky easing of policy. Mr Greenspan, an enormously able and experienced man, is undoubtedly aware of these risks. And yet he seems far more willing, as throughout his time as Fed chairman, to cut rates than to raise them. (Most of his critics, we acknowledge, attack him for exactly the opposite reason, but then we have always had far more respect for Mr Greenspan than for those critics.) Still, one cannot help wondering whether the Fed knows something the rest of us do not about financial fragility in America. Perhaps some specific, impending and possibly contagious calamity, another LTCM, needs to be headed off. If so, the markets will presumably soon regret their spasm of exuberance on January 3rdand we will soon applaud the Feds prompt, not precipitate, action in cutting rates. Barring such alarming possibilities, the Feds haste is difficult to understand and even more difficult to defend. _______________________________________________ Crashlist website: http://website.lineone.net/~resource_base
