Greenspan's new inflation vigilance.

Author:England, Robert Stowe
Position:Federal Reserve Board Chairman Alan Greenspan

Alan Greenspan is one of those rarities in Washington. He's been Fed chairman for nearly seven years, and his reputation is still rising. But the job may be entering its toughest phase yet, as the economy heats up and inflation starts to rear its ugly head.

"We used to have a debate in our universities, you know, zero inflation versus jobs," said Representative Toby Roth (R-Wisconsin), to Federal Reserve Chairman Alan Greenspan at the February 22 Humphrey-Hawkins hearing before a key House subcommittee. "In other words, you had some inflation to create jobs. It was good for the job market if you had some inflation. Is that all heresy today?" Roth asked.

"Yes," was the one-word reply of the normally loquacious Greenspan, who had already patiently debunked what Roth referred to, which was the mainstream Keynesian view of macroeconomics that had prevailed for the first three decades after World War II. In doing so, Greenspan publicly completed for the Federal Reserve the long intellectual journey begun by his predecessor Paul Volcker, who inherited the worst inflationary environment of any Fed chairman since the Federal Reserve System was founded in 1913. Volcker managed to largely wring out the worst of it from the economy by the time he left the Fed in 1987.

The one-word answer was also remarkable for its certain, almost absolute quality. So rare is such an utterance from a Fed chairman that reporters in the press section looked at each other in astonishment. One veteran reporter turned to the others and said, "That's the best answer he's ever given." That might not prove far from the truth.

While Greenspan had already told the Joint Economic Committee on January 31 that the old paradigm on inflation and growth was dead, the Federal Open Market Committee (FOMC) put actions behind those words. On February 4, the FOMC approved the first increase in the federal funds rate since 1989, when that rate peaked at 9 3/4 percent. The quarter-point increase in the target for the federal funds rate, which rose from 3 percent to 3 1/4 percent, was done as a preemptive strike against inflation, which has been running at around 3 percent. The move took on added punch when Greenspan announced it rather than waiting for the markets to discern it from Fed market actions.

The Fed acted again on March 22 to boost the fed funds rate to 3 1/2 percent. The two back-to-back moves raising short-term rates confirm Greenspan's intent to act before inflation has clearly taken hold, rather than wait for clear signs of inflation.

Chairman Greenspan and the Fed are now widely given credit for successfully taming inflation significantly below the levels that former Fed Chairman Paul Volcker had achieved. This noteworthy achievement is a product of the policies the central bank has pursued in the nearly seven years since Greenspan replaced Volcker.

Even after recent increases, long-term interest rates are at their lowest in decades--although not as low as the 3.75 percent to 4 percent levels before the Vietnam War, the milestone event that separates the early postwar noninflationary period from the inflationary era that followed and is only now winding down. As Greenspan testified February 22, the outlook for the economy is "the best we have seen in decades."

Many economists across a broad political and ideological spectrum agree with Greenspan that the Fed's success on the inflation front has laid the groundwork for steady, noninflationary real growth averaging around 2.5 percent to 3 percent a year for the foreseeable future, barring unforeseen shocks to the economy. Greenspan computes the optimum, noninflationary growth level by adding the real growth in the labor force to gains in productivity, which has been rising rapidly in recent years

Implicit in this new, more sanguine view of future economic possibilities is a new paradigm that has firmly taken hold at the Federal Reserve. Greenspan did more to explain that new view on February 22 than he has on previous occasions. "We would like to replicate what occurred in past history, very considerable economic strength and long expansions without inflationary imbalances," Greenspan told Congress.

He reviewed for the House Subcommittee on Economic Growth and Credit Formation what the Fed had now learned about the relationship between inflation and growth. For starters, "inflation is not necessarily a consequence of growth." The corollary to that, he explained, is that "there is no downside to low inflation, it's consistent with the maximum increase in growth and the highest level of growth in productivity." Furthermore, inflation will not flare up, he said, unless the Federal Reserve provides the "financial tinder," meaning accommodative monetary policy. The benefits of taming inflation, on the other hand, are now viewed by the majority of economists as greater than previously thought, he argued.

This new view contrasts with the views held before 1980 when it was assumed that "a mildly increasing rate of inflation greases the wheels of economic growth and lower rates were detrimental to the system. This has been shown to be false," Greenspan said.

This is not only a long intellectual journey for the Fed, but also for Greenspan, who personally subscribed to the old view when he was chairman of the Council of Economic Advisers in the Ford administration from 1974 to 1977. One of his professors at Columbia University, Arthur Burns (himself a former Fed chairman), espoused the notion that there is a trade-off between inflation and growth, which the Fed has now rejected. Burns, who served as chief of Eisenhower's Council of Economic Advisers, and who considered himself an inflation fighter, nevertheless, went on to become Federal Reserve chairman in the postwar era, presiding over the Fed from 1970 to 1978 when inflation took off.

Greenspan had already become a committed inflation fighter when he was appointed chairman in 1987. Even so, inflation hawks have criticized the Fed chairman for straying too often from fighting inflation to managing the business cycle. Greenspan's latest testimony and the Fed's recent rate increases suggest he has strengthened his commitment to fighting inflation. Even some inflation hawks are impressed. Under Greenspan, the Fed has made "a progressively increasing commitment to keeping the inflation rate low, as distinct from managing business cycles," says William A. Niskanen, the chairman of the Cato Institute and a former acting chairman of the White House Council of Economic Advisers under President Reagan.

When Representative Roth asked Greenspan if the Fed has a game plan like a football coach, the chairman largely agreed. "To some degree," he responded, the Fed does have something like a game plan--"a philosophical structural framework" that explains how the economy works and responds to monetary policy. "Thirty years ago, we didn't know how economies responded to monetary policy," he said, but during the past two decades, there has been a considerable increase in knowledge about how economies work from macroeconomic research at major American universities. "We |now~ know that if we do x, then y is likely to happen," he explained.

A key element in Greenspan's new price stability policy is his willingness to act to counter inflationary expectations, instead of waiting for clear evidence that inflation is already occurring. The reason for this action, he said, was that there was a considerable lag of a year or more between the time that the Fed took an action and the time it affected the economy. Waiting until inflation was in place was "looking in the rear-view mirror" he told Representative Paul E. Kanjorski, chairman of the House Subcommittee on Economic Growth and Credit Formation. When Kanjorski asked why the Fed raised rates when there was no evidence of inflation, Greenspan said that the more pertinent question is, "what are the processes in development now that will affect price pressures later on as we progress into 1995 and beyond?"

Congressman Kanjorski was not satisfied with Greenspan's answer. "We wonder if it's a matter of studying entrails or is there an objective tool" to measure inflationary expectations? Greenspan, who is said to thrive on studying the mass of economic data that pours into the Fed's research department, could not, of course, say the Fed had no objective measure of inflationary expectations, that it is all a matter of judgment--that the Fed is largely "flying by the seat of its pants," to use the standard metaphor.

Yet, from all the advances in the science of predicting the effect of changes in monetary policy on the economy, the tools of monetary policy remain horribly inexact. Thus, monetary policy remains more of an art than a science, according to David M. Jones, chief economist for Aubrey G. Lanston in New York, perhaps the leading Fed watcher outside academia.

As economists would tell you, a focus on inflationary expectations would lead one to watch spot prices for industrial commodities, from oil to aluminum, lumber and cotton. But, Greenspan also identified the price of gold as an important indicator of inflationary expectations in his testimony. Representative John J. LaFalce (D-New York) dismissed the notion of following gold prices, suggesting it was "a guessing game." "I don't think so, Congressman," Greenspan replied. "The price of gold reflects a basic desire to hold hard assets rather than currency." Because virtually all the gold ever produced still exists, Greenspan argued, and a change in new production will not appreciably affect the price of gold, it is "a reasonably good indicator of inflationary expectations."

Greenspan observed that following gold was more helpful than following some spot prices of industrial commodities, which are affected by both supply and demand. "I believe things were better when we had a gold standard," Greenspan added to underline his admiration for this indicator.


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