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Friday May 7, 2004 - 22:11:37 GMT
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Getting Inside Greenspan's Head (FXA)

Getting Inside Greenspan's Head (FXA)

The April US non-farm payrolls numbers and for that matter nearly every component in the latest month's employment report indicated a labor market kicking into gear over two years into a recovery and more recently behind robust growth rate fuelled itself by strong corporate profits, solid consumer spending and an extraordinary round of tax cuts and spending increases. Firms, households and the government are spending. Perhaps not with reckless abandon. But in a synchronized fashion that has not been observed in several years. For most observers of central banking, the case for tightening policy is strong. It is stronger today than Tuesday when then Fed chose to leave rates on hold at 46-year low, but it was arguably strong on Tuesday.

Since Greenspan is a man of high intelligence, as presumably are his fellow FOMC members, one has to ask why the Fed is so reticent to begin "normalizing" interest rates. Remember the last two rate cuts of 2003 was an insurance policy against deflation. With deflation no longer considered a risk by the Fed, why is the deflation insurance policy still fully in place?

As I have said many times before I think some acknowledgement must be given to the unstated concern at the Fed of a credit market bubble that is the result of maintaining ultra-accommodative monetary policy. And for the most cynical some might argue Greenspan has yielded to politics of an election year. But these views the fringe holds, not the mainstream and hence I won't fill space with it here.

Rather it is a worthwhile exercise to get into the head of Greenspan and see the world the way he does, not the way I do nor the way he should. He has two Congressional mandates in front of him - maximizing employment (growth) while simultaneously maintaining price stability. It follows that in a period of slack resource utilization in labor and product markets, high productivity and low rates of inflation, the Fed pays more attention to full employment over price stability. Indeed in this frame of mind some inflation is a good thing and lubricates growth and employment. So the reticence to hike is not so much about exploring how long rates can be held at four-plus-decade lows before unwanted inflation emerges, but it is about taking advantage of the unique period of low inflation and slack resources to allow for employment growth.

And now two solid months of jobs growth does not obliterate 26 months of fairly dismal payroll figures. Greenspan wants to let the party run before taking the punch bowl away. The participation rate is still troublingly low, as are the number of claimants losing benefits, especially in March. Productivity rates remain above the historical average checking wages, lifting profits and providing firms with a buffer to absorb higher input costs (commodities). In other words the labor market is anything but tight and still not convincingly tightening.

Then the growth engine may not be as sound as it appears on the the GDP 4-plus-percent pace in the last three quarters. The impact of the tax cuts is diminishing. Gone is the one-time child-tax credit if 2003. The spending pipeline looks set to grow ($25bln additional funds have been requested for Iraq and Afghanistan for starters). So the fiscal juice is running at a reduced rate.

Then there is the petroleum tax on firms and households. Record high gasoline prices, albeit not the impact of the 70's, is a drag on spending. And while we like the assume it is transitory, it is panning out as rather sustained.

Then there is the ongoing issue of the escalating risk of a terrorist attack in the US or perhaps elsewhere that could have a negative impact on economic sentiment and agents slow spending and investment. While I would never suggest the Fed is making policy with the notion of imminent terrorist attack, it is equally important to recognize where the Fed would be with several rate hikes under its belt by the fall and something were to happen on the terrorist front.

Again I do not fully buy the logic, but it is clear that Greenspan and the Fed have moving rationales when it comes to justifying low interest rates. It now has the burden of raising rates in a measured way, but from the standpoint of still focusing mostly on full employment and much less so on inflation. Measured removal of deflation insurance (50bps) seems reasonable this year. June30 is perhaps the first move, but still August10 is perhaps more in line with the Greenspan thinking. And maybe the next one in September, maybe not. This is the Greenspan mind.

What makes for a faster measured pace? The markets. The data. The markets are manic...look where bonds were a month ago ahead of March payrolls even with the Fed warning of a need to remove accommodation. The Fed can only jawbone the market in its direction to a point. And markets pull the Fed in its direction. They meet in the middle more or less. And then of course the data will provide the tie-break...whether it is more where the market believes the Fed should be or more where the Fed believes the market should be.

David Gilmore


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