Who’s in charge at the Fed?


Last Tuesday, the markets were euphoric when the Federal Reserve signaled that it was adopting a neutral stance on future interest rate hikes.  It was Fed Chairman Alan Greenspan’s last hurrah as the most influential Federal Reserve chairman in U.S. history.  Incoming Chairman Ben Bernanke took over this week and will chair the March Federal Open Market Committee (FOMC) meeting.  Markets soared when investors thought that the Fed had finally decided it was close to a neutral bias on subsequent interest rate hikes. 
 
So much for the brief lovefest between the markets and the Federal Reserve.  On Friday, the monthly jobs report came in stronger than expected, and the unemployment rate dipped from 4.9% to 4.7%, signaling that the U.S. economy is stronger than expected.  With labor markets tightening and an increase in wages likely, an inflation spike could soon follow.  If that occurs, the Fed would then move to cool the economy by further raising interest rates.  Yesterday the markets tanked on positive economic news, fueled by fears among investors that the Fed will shed its neutral stance and continue to aggressively raise interest rates.  Investors already anticipate that the FOMC will raise rates in March, but the markets are hoping that Fed will soon end its incessant urge to raise rates by a quarter point each time it meets.
 
This is a critical time in the U.S. economy.  If the Fed overreacts, it could send the economy into recession.  If its response is too passive, it could fuel out-of-control inflation or even stagflation.  Although I’ve been critical of some of Greenspan’s policies, I appreciate that he has anticipated market dynamics that defy traditional economic models.  For example, he anticipated accelerated productivity gains fueled by technology advances in the 1990’s.  Productivity gains helped curb inflation in the mid-1990’s, and Greenspan rightfully opposed interest rate hikes that could have deflated the Internet boom.  His successor, Ben Bernanke, has a much different interest rate philosophy.  Bernanke is a well-known advocate of targeted interest rates who prefers to use formulas to determine what the optimal interest rate.  Both men’s philosophies have merit at different stages of the economic cycle, but only one is appropriate at this stage.
 
The primary question facing the Federal Reserve right now is this–given high energy prices, a strengthening economy, and flattening productivity curve, should interest rates be raised to dampen inflation?  If energy prices decrease, or productivity picks up, further interest rate increases might not be necessary.  Neither appears to be true, unfortunately.  Energy prices will stay high through at least 2006, and increased hiring and higher wages indicate that economic growth is outpacing productivity gains.  Still, is inflation inevitable in today’s economy?  Does the Fed need to continue raising rates to fight inflation that has not yet materialized?  If Bernanke has his way, the answer would likely be yes, because economic models presently favor more rate increases.  Under Greenspan, the response would be more innocuous.  Greenspan would likely favor continuing the Fed’s neutral bias and wait for further inflationary pressures to appear before adopting a more aggressive anti-inflationary stance.  Bernanke will likely stay the course, which I hope translates into a Greenspan-style approach in the near term.
 
Regardless of who is really in charge at the Federal Reserve right now, I hope that the Fed considers that the U.S. economy has been sluggish for awhile and agrees that it is better to let the economy strengthen before succumbing to inflation fears.  In the past five years, the U.S. economy has weathered a mild recession and remained somewhat sluggish, survived two major disasters (9/11 and Hurricane Katrina), suffered through a major stock market crash and the dot.com bust, and seesawed from deflationary fears to anxiety over high energy prices.  Yet through it all, inflation has remained in check.  The Fed needs to temper its inflation fears and give the U.S. economy room to move.  I hope whoever is in charge doesn’t put a brake on the economy too soon.
Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s