Trying to Read the Fed Chair’s Two Minds on Interest Rates

Diary entry of Alan Greenspan, Friday, May 2, 1997

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Dear Diary: Andrea and I had a great honeymoon, but now comes the downside: culling through our wedding gifts and writing thank-you notes. You wouldn’t believe how many of our Wall Street friends gave us glass, marble or bronze sculptures of a bull fighting a bear. Sheesh--how creative are these guys?

Anyway, I’m also thinking a lot about the May 20 Fed board meeting, of course. And after last week--well, who knows what to think!

I guess Americans assume I have a crystal ball for interest rates and the economy, but the truth is I sometimes get just as confused as everyone else. I’m looking at the same mixed-up data they are, after all. Why do they think I talk in circles at those congressional hearings?

Last week I, like many people who pay attention to this stuff, was stunned by the small, 0.6% rise in the first quarter’s employment cost index, a government measure of total compensation growth--including wages, salaries and benefits--across the broad economy.

I’ve been harping about the tight labor market for months, because many of the reports I get from our 12 regional Federal Reserve banks point to the trouble employers are having finding, and keeping, workers. Wouldn’t you think compensation costs would be rising more rapidly than the 2.9% they were up in the year ended March 31--especially with the economy’s red-hot 5.6% growth rate in the first quarter, the fastest in a decade?

Then came Friday’s April employment report. Go figure! The unemployment rate drops to a 23-year low of 4.9%, but production workers’ average hourly earnings actually are a penny lower than in March, at $12.14.

On top of that, Clinton and congressional leaders announced that they’ve got a balanced-budget plan. I’m as skeptical as anybody that this plan will do the job, but financial markets evidently aren’t: Bond yields fell to eight-week lows Friday, and the Dow Jones industrial average soared 94.72 points to 7,071.20--just shy of its all-time high of 7,085.16.

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So I know what people are thinking now: “Greenspan is a chump!” They think that I had no good reason to raise interest rates March 25 and that I certainly have no reason to raise rates again on May 20. The markets are telling us that the economy is just fine and will only get better if Uncle Sam finally balances his checkbook.

Americans think I’m a reactionary; they think I don’t understand how the world works today.

Last year, I gave the economy the benefit of the doubt, leaving interest rates alone even after the economy grew at a strong 4.7% pace in the second quarter. Sure enough, growth ebbed again in the third quarter before rebounding again in the fourth.

More important, we never saw price inflation begin to accelerate as feared last year, even though by some measures workers’ earnings in 1996 rose at the fastest rate since 1990.

It’s the same basic story this year: There’s no significant price inflation at the grocery store, the department store, etc. Heck, Big Macs are now 55 cents at McDonald’s! If it wasn’t for my cholesterol count, I’d probably be wolfing them down the way Clinton does.

Of course, I understand the forces at work here. For one, worker productivity is almost certainly better than what the government’s measures of it show. All that technology equipment sold over the last six years must be doing some good. If people can produce more in less time, we get good growth without the need for companies to raise prices--and workers can be paid more, to boot.

Then there’s the globalization of free trade, or at least freer trade, in the 1990s. Everybody on the planet is a capitalist these days except Castro and that guy in North Korea, what’s-his-name. I know it’s tough for most companies to think about raising prices because someone somewhere in the world may quickly step up and offer a cheaper product.

The strong U.S. dollar is just punctuating that issue for American companies this year. It’s no coincidence that Toyota, Honda and BMW saw their U.S. car sales rise in April, while Chrysler and GM saw sales decline. If that forces U.S. auto makers to cut prices or offer rebates in the months ahead, there’s another blow struck for low inflation.

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Who’s to say this great environment can’t continue for another couple of years? Look at the Europeans--they’re just beginning to get the idea that their companies have to be competitive, keep prices low, boost productivity, etc. In China, that massive labor force has only begun to be tapped for world production (and for consumption, too, I might add). And what if the Russians and the Indians get their acts together? How competitive might they be with us?

I know all this. I’m 71 years old, but I’m not set in my ways. I’m a little miffed sometimes that I don’t get much credit for this long economic expansion. I’m the one who kept interest rates extremely low from 1991 through 1993, to allow the economy to rejuvenate itself after the 1990 recession and the hangover from Reagan’s 1980s.

And when I raised rates in 1994, I did so to wean the economy from that low-cost money before it allowed too many people to do crazy things. Some already were--like borrowing short-term to buy long-term bonds. People like that, including that Orange County treasurer with the vodka name--Citron!--got burned in 1994, but big deal. The damage was pretty limited overall, if you ask me.

And wasn’t I right? The economy didn’t crash. Yes, we grew pretty slowly in 1995, but that was the point: I want to stretch out this economic expansion, not kill it. Do people really think I enjoy recessions? What’s in them for me, except ridicule and scorn?

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The point is, I’m paid $133,600 a year to anticipate trouble and to use interest rates as a tool to try to avoid really big trouble. No economic data can predict the future, so ultimately I have to go with a gut feeling.

I know that fast economic growth, by itself, doesn’t necessarily generate higher inflation. But it is true that boom usually leads to bust. An unemployment rate under 5% could--I said could--set the stage for higher wage and price inflation. And history shows that once an inflation cycle starts, it’s hard to stop it.

So if I want to inject just a little more discipline into the economy, a “reality check” after the strong growth of the last 12 months, how much harm can I inflict by raising short-term interest rates another measly quarter point, to 5.75%?

But now I’ve got two major problems, dear diary. One is this balanced-budget plan. I’m on record as saying the Fed would have to be accommodative with interest rates if the government got serious about ending deficit spending.

I don’t think many people inside the Washington Beltway truly believe that we’ll have a balanced budget in the year 2002. But that’s beside the point. The Fed will now be expected to play along. If I raise rates on May 20, I will be vilified.

And then there’s the stock market. I’ll admit, I’ve painted myself into a corner here. I thought it was prudent in December to raise that “irrational exuberance” question--and I really only meant it as a question.

I raised the issue again in March. I have no idea where stock prices should be. But earlier this year my Wall Street friends all conceded that by historical measures, stocks were richly valued.

I just don’t want us to repeat Japan’s nightmare. Their market became more and more overvalued in the late ‘80s. Look at it now: Seven years after the Nikkei-225 stock index peaked at 38,915, today it’s at 19,514--still down 50%!

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But now I’m trapped. If I thought the U.S. market might be overvalued in March, and already the Dow is on the verge of new highs, is this any less irrational? Should I publicly suggest that stock prices might be “OK” now just because the market fell almost 10% over the last two months (a lot more, for some stocks) and thus washed out some of that exuberance?

If I don’t raise rates on May 20, it will be viewed as a green light on Wall Street, and who knows how high stocks might go. If I do raise rates, people will think I’m just trying to hurt the market again. I can’t win.

Anyway, Andrea’s calling from downstairs, so I have to go now. More thank-you notes to write. I still have no idea what we’ll do with rates on May 20. But maybe if I stare at some of these dumb bull-versus-bear sculpture wedding gifts for long enough, it will come to me. . . .