At the last FOMC [Federal Open Market Committee] policy-setting meeting back in March, the members left interest rates unchanged. Whats more, they ducked the question of whether the balance of risks in the US outlook tilted toward greater economic weakness or more inflationary pressures. They gave the Iraq war as an excuse. The war is over, but the uncertainties about the economic outlook have not been cleared up yet.
A remarkable event took place since then. President Bush decided to announce he was offering to reappoint Greenspan a full year before his term expires, and Greenspan accepted. The White House came to the decision even though the Fed Chairman had publicly distanced himself from the administrations budgetary and tax proposals. The reason is that they have no obvious candidate to replace Greenspan who would instantly command allegiance from the financial markets. Naturally, the Bush political team is counting on a revival in the US economy to assure the Presidents reelection next year. The political advisers know that will be hard to accomplish if the stock market stays low, even harder to pull off if the stock market were to fall further. Replacing the Federal Reserve Chairman is bound to upset the markets, at least temporarily, so why risk it, unless there is a cant miss candidate? And there isnt.
Against this backdrop, Greenspans hastily-scheduled testimony to a House of Representatives committee this week was eagerly anticipated by financial market participants. They were more than usually interested in hearing what Greenspan had to say about the economy, what his concerns were, and whether he would tone down his criticism of the Bush administrations economic policy approach. What he said did not, unfortunately, clear the air, either about economic prospects or the debate over fiscal policy. However, what he left unsaid namely, that the news about inflation has been systematically bad so far this year showed the true balance of opinions among the Federal Reserve governors and regional bank presidents. This is a central bank in which there is far more worry about disinflation than a revival of inflation.
Three points from Greenspans testimony deserve close attention.
First, he expects a pick up of economic growth. In his words, the economy is positioned to expand at a noticeably better pace than it has during the past year. But that was hardly a ringing endorsement. And he was hard put to offer any new evidence to support it.
US GDP growth
Q4 2003 over Q4 2002
Federal Reserve 3-3.75%
Everyone knows that the weakest link in the US economic situation has long been the contraction in business fixed investment. Capital expenditures fell again in the first quarter of 2003, according to recently released GDP statistics. Their prospects are by far the largest uncertainty confronting the US economy today. Greenspan was able to tell the members of Congress that a modestly encouraging sign is provided by the backlog of orders for non-defense capital goods excluding aircraft, which has been moving up in recent months.
In fact, the rise has been very small, less than $3 billion. The orders backlog is still about $35 billion below the peak reached in 2000, a net decline of 20%. Greenspan may well be right that the slight increase in orders backlogs is evidence the worst is over for capital spending. But that is not what business executives are saying in the ISM purchasing managers report or in the various regional Federal Reserve Bank surveys.
Second, if the predicted upswing does not materialize, the Federal Reserve has ample flexibility to provide additional stimulus. Greenspan correctly pointed out that this is not a new position, but reiterating it naturally raised the question of whether fiscal stimulus might also be appropriate, even necessary. He threw cold water on that notion. When there is a need for temporary demand stimulus, he believes monetary policy is better suited to the task than fiscal policy, which takes longer to legislate, is harder to reverse, and less flexible to administer.
Republicans and Democrats alike tried to tease helpful answers out of Greenspan on the politically divisive issue of President Bushs budgetary and tax cut proposals. What about budget deficits? Large, sustained ones tend to raise long-term interest rates, he replied. He cited a newly published Federal Reserve staff study by economist Robert Laubach that estimated a one percentage-point increase in the government deficit to GDP ratio produces a 25 basis-point increase in long-term interest rates. Bush economic advisers deny any such relationship. Does that mean taxes should not be cut? No, tax cuts are good, since they expand the private sector and help stimulate investment. But that means government spending must be reduced in order to keep tax cuts from raising the deficit? Yes. But what spending? That is up to the Congress to decide, Greenspan insists.
Third, the Fed Chairman is no anti-inflation hawk. Quite the contrary. He brushed aside the sharp increases in the producer price index and in the employment cost index so far this year, asserting as you know, core prices by many measures have increased very slowly over the last six months. But the clincher was his nod to those among his Fed colleagues who are worried that the economic recovery is stalling and that downward pressures on prices will worsen the profitability of business and thus stunt any capital expenditure rebound. The key sentence is the following: With price inflation already at a low level, substantial further disinflation would be an unwelcome development, especially to the extent it put pressure on profit margins and impeded the revival of business spending. What this means is that the Fed is effectively following an informal inflation target and it wants the core rate of inflation to go up.
The US stock market didnt know what to make of the Chairmans testimony, and it fluctuated back and forth with little net change. The bond market liked what it heard: that the Fed is actually biased toward easing monetary policy again and may do so rather soon if the economy doesnt pick up by summer. Bond prices accordingly rallied sharply. Since lower interest rates and weak economic growth in the United States would encourage investors to go elsewhere, currency traders pushed the dollar down further against the euro and even against the yen. These developments could not have been unforeseen by the Fed Chairman and presumably are in the desired direction of lifting US growth and inflation.