Last week saw the definitive end to the cheap money that refuelled the United States and world economies in the dark days of the dotcom bust, September 11 and the war in Iraq.
The US Federal Reserve, the world’s most powerful central bank, increased the federal funds rate to 1,25%. It is the first rate increase in four years.
For the past year the bank, led by the redoubtable 78-year-old Alan Greenspan, sworn in last week for a fifth and final term, has sought to ensure the economy is firmly back on track after its three-year slowdown by keeping rates rock-bottom. In real terms, adjusted for inflation, they are negative. That job looks done or, possibly, as Greenspan’s detractors say, overdone. Economic growth is steaming along at an annualised 4%, factory output is booming, and confidence among consumers and businesses is high.
And the recovery, long dubbed ”jobless”, is now generating a quarter of a million jobs a month, offering President George W Bush the chance to avoid becoming the first president since Herbert Hoover to preside over a net loss of jobs. Indeed, some argue that Greenspan, whose rate rises in the early 1990s have been cited as one reason George Bush Snr did not win re-election in 1992, has delayed tightening policy this time because an election is looming in November.
While Greenspan has retorted that he wanted to wait until the economy was creating plenty of jobs, inflation has now begun to rear its ugly head. The headline measure has moved up to 3,1% from 2,1% a year ago while even core inflation, which strips out rising oil prices, is up to 2,0% from 1,1%.
The crucial question now is how the Federal Reserve should wean the US economy off the medicine of ultra-cheap money without causing nasty withdrawal symptoms such as a collapse in the over-heated housing market. The US economy is also carrying some nasty imbalances apart from the housing market. There is a record current-account deficit and huge budget deficit, thanks to Bush’s big tax cuts and spending on the war in Iraq.
Greenspan is thus walking a tightrope and, arguably, without a safety net beneath him. Rates are clearly too low, say the critics, and have been for too long. But the last time the Federal Reserve raised rates quickly — from 3% to 6% in 1994/95 — financial markets suffered a meltdown, with knock-on effects on the economy. It is clear that policy- makers around the world are casting nervous glances across the sea to the US, fearful of the impact on their own economies should the Federal Reserve mess up.
The Bank of England’s Alistair Clark crystalised the concerns: ”Managing the process in a way that generates minimum disruption will call for considerable care both in determining monetary policy and in its presentation.”
Small wonder, then, that Greenspan has stressed the Federal Reserve’s gradualist approach and has used the word ”measured” to describe the likely pace of rate rises. He has also argued that ”inflationary pressures are not likely to be a serious concern in the period ahead”, but that the Federal Reserve will do ”what is required to fulfil our obligations to achieve the maintenance of price stability”. In other words, ”rates are going up slowly but we’ll speed up if we have to”.
A key part of managing inflation is controlling workers’ and firms’ expectations about it. Give the impression that you have lost your grip on it, and people demand bigger pay rises and companies raise prices. But stamp down too resolutely with rate rises and you can tip the economy off the edge.
So all eyes will be on the language the Federal Reserve uses to accompany its rate rise, particularly how the word ”measured” is used, for any hint that the bank may raise rates more quickly than markets are expecting.
For now, at least, economists think it will bide its time, raising rates in quarter-point increments to 2% by the end of this year and 3% a year from now. But after that things are murkier. It is clear from statements from Federal Reserve officials that there is little agreement about how high rates may have to go to no longer stimulate the economy, known as the ”neutral” rate. They have offered their own ideas in recent times, ranging anywhere between 3% and 5%.
”They are starting off on a journey but they don’t know what the destination is,” says Stephen Lewis, chief economist at Monument Securities in London. ”I think they will carry on raising rates until the economy shows signs of slowing down, then they will stop.”
The key lies with inflation. The gradualists on the bank’s rate-setting committee argue that the recent rise is only temporary and will pass. Oil prices appear to have stabilised to less than $40 a barrel and unemployment, at 5,6%, shows that the economy still has lots of slack to be used up before the labour market starts to generate any upward pressure on wages and prices.
But pessimists point to the fact that, as inflation was very low last year, so-called ”base effects” will mean some high reported numbers this year. That could have a big upward effect on Americans’ views about inflation. Figures show expectations have already picked up to above 3%.
So if inflation does take off, Greenspan could well be proved to have been behind the curve. And if he has to play catch-up, talk of rates peaking in the 3% to 5% range may be over-optimistic. The last peak, four years ago, took rates up to 6,5%.
Just as the fiscal and monetary loosening of the early years of the new millennium have bought the US, in the words of former International Monetary Fund chief economist Ken Rogoff, the ”best recovery money can buy”, so a combined tightening may just slow things down nicely.
But if things go wrong, Greenspan will go down in history as the Federal Reserve chief who lost the plot. — Â