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June 7, 2005

Greenspan's Real Conundrum

Greenspan has not had the most flattering pictures in the press lately. First, there was CNN's "YodaSpan" picture. Today, AFP chose this picture for its story on Yahoo News about Greenspan's call for China to adopt a more flexible exchange rate.
While the pictures are perhaps a conundrum Bloomberg’s Caroline Baum, who had nothing to do with the pictures, identifies “Greenspan’s real conundrum,” what to do with short-term interest rates. Should the Fed take the signals of inflationary pressure seriously and continue tightening, or “heed the message of the market encapsulated in the flattening yield curve and call it quits?” Baum believes that the Fed will interpret recent data as exhibiting inflationary tendencies and tighten accordingly, so the conundrum is when to level off or reverse the increase in rates. Here she is much less certain in her prognostication, but notes that due to the lags inherent in monetary policy, the Fed should ease policy once there are signals of weakness even if price data continues to show inflationary pressure. [Update 6/21/05: In response to an email comment, I reread Caroline Baum's article and I don't think I represented her views as accurately as I should have. Rather than trying to interpret her words once again and risk repeating the same thing, I encourage you to read her remarks in full so that she may speak for herself.] The general message, in the end, is one I agree with. As of now, there is little to suggest that the Fed will deviate from the path of measured rate increases. With its commitment to increased transparency, with just about every analyst expecting a 25-basis point increase, and with probabilities derived from Federal Funds futures supporting that expectation, to do anything different would constitute the type of surprise the Fed seeks to avoid in its current policy regime. The second part of the message is to keep an eye on the totality of data on employment, output, inflation, etc. for signs of weakness in real activity. Because of the lags in policy, even if price data continue to exhibit inflationary pressure, sufficient weakness in indicators of real activity will cause the Fed to take a breath and assess whether further increases are warranted. I will also add that we should listen carefully to messages from Fed officials. For example, Greenspan speaks later this week and will likely seek to clarify the Fed’s position in light of recent statements by Fed officials:
Greenspan's Real Conundrum Isn't Long-Term Rates, Caroline Baum, Bloomberg: Ever since Federal Reserve Chairman Alan Greenspan made "conundrum'' a household word in February, the term has been used to describe the behavior of long-term interest rates. Specifically, this is the first time in recorded financial history that the Fed has jacked up short-term rates only to find long-term rates exhibiting a mind of their own. … So what's a good central banker to do? Will the Fed continue to boost short-term rates, even if it means inverting the yield curve, in an attempt to normalize rates to some unknown neutral level and to skim the froth off the housing market? Or will policy makers heed the message of the market encapsulated in the flattening yield curve and call it quits? This is Greenspan's real conundrum. Dallas Fed President Richard Fisher's "eighth-inning'' baseball metaphor last week notwithstanding, there has been nothing from the Fed to suggest an end to the cycle of rate increases … Fed officials have said in every way except via the language in the policy statement that they're more concerned about accelerating inflation than slower growth. Given their focus on wages as the driver of inflation, the news last week that unit labor costs in the non-farm business sector rose at a 4.3 percent year-over-year rate flashed yellow on their radar screen. The actual inflation news isn't all that great either. While the CPI excluding food and energy was unchanged in April from the prior month, core services prices (services excluding energy) rose at a three-month annualized rate of 3.8 percent, challenging the notion that the current inflation is "all energy.'' As recently as January, core services were rising at a 2.4 percent pace. Greenspan's dilemma -- his real conundrum -- isn't long-term interest rates, which are set by the market. It's what to do with the short rate. … Let's assume the Fed fulfills market expectations for 25-basis- point rate increases at the June 30 and Aug. 9 meetings, putting the funds rate at 3.5 percent. There is no reason to expect long- term rates to get with the program at this juncture and move higher. So come the Sept. 20 meeting, Fed officials will be confronted with a pancake-flat yield curve. What will Greenspan do with the short rate? With his term as a Fed governor ending next January, he might want to take a trip down memory lane … The time is Feb. 22, 1995 … After explaining that monetary policy acts with a lag, which required aggressive tightening to stave off "inflation pressures not yet evident in the data,'' Greenspan switches gears. "Similarly, there may come a time when we hold our policy stance unchanged, or even ease, despite adverse price data, should we see signs that underlying forces are acting ultimately to reduce inflation pressures,'' Greenspan says. Easing is nowhere on the horizon. And the last thing Greenspan wants to do is goose the housing market by giving markets the green light. Still, there may come a time in the not-too-distant future when Greenspan's caveat is applicable again.

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