In early December Federal Reserve Chairman Alan Greenspan spoke about a material slowing in the rate...
In early December Federal Reserve Chairman Alan Greenspan spoke about a material slowing in the rate of growth in the US economy, and the stock market went into wild euphoria. There is a lesson here about the importance of people's expectations for the actions of public policy makers such as Greenspan.
A few years ago, I shared an early morning ride to the airport with a friend who is a well-known academic economist. In the course of the trip, my pager started beeping with the announcement of blowout government statistics on non-farm payrolls: bigger employment growth than anyone expected. I told him what had happened. Then I quipped, "kiss the bond market goodbye'' as I watched bond futures prices plunge.
The professor said "I thought you just told me there was a tremendous improvement in labour demand. Isn't that good news?''
"Dear friend,'' I intoned, "it would be good news except there is a man in Washington named Greenspan. And this man thinks it is necessary for him to remove the punch bowl whenever the party gets interesting, to paraphrase former Federal Reserve Chairman, William McChesney Martin.'' What I meant is the flip side of employment growth can be a tighter labour market that could lead to higher wages and prices, thus inducing the Fed to raise interest rates.
"So what is it you are trading?'' he asked. "We are trading Greenspan, the Bundesbank, and the Bank of Japan. We are trading in a guessing game about what will be the next round of central bank policy. That's what the market has become.
"And to make it more confusing, they, meaning the central bankers, are spinning us left and right. If they get us worked up enough, they don't have to do anything because we, the market, will do their work for them. It is like the perfect crime. Their fingerprints are not on the murder weapon.''
In fact, this is why the analysis of public policy is such an enormously complex business. The authorities have a tremendous advantage in their ability to influence the market without actually instituting a formal policy action. The right words can do just as much good, or bad, as change in an important policy variable like the targeted rate for overnight interbank lending, the so-called federal funds rate.
That is what we saw happen when Green-span spoke.
It was a dose of Fed talk that changed inves-tors' expectations. The good news is the Fed chief is probably signaling he is done with this cycle of interest rate increases. The bad news, totally forgotten in the stampede to buy stocks that day, is the previous set of rate increases may have materially slowed the progress of the US economy.
Hence the topic of interest now turns to how fast the Federal Reserve will reverse its tight-money policy. The new significant event Fed-watchers are looking for is the Federal Open Market Committee deciding to remove its declared bias toward raising rates. Following that, we may see the Fed begin to drop short-term interest rates.
What I find amazing is how accepting people are of the notion the Federal Reserve is capable of doing fine-tuning on the economy. You cannot have a discussion about the US economy without someone dishing out the standard dose of Greenspan hero worship. Things have been going so well for so long in America that the omnipotence of the Greenspan Federal Reserve is an unquestioned belief.
Yet the world is a very dangerous and tricky place, where your survival is often dependent on anticipating a paradigm change when none is anticipated. I find it a very dubious proposition that a central bank could have the ability to successfully and repeatedly moderate economic growth cycles.
And in the trench-warfare environment of today's trading where the central banks and the market participants are constantly eyeballing each other, trying to psyche each other out, the chance of major unexpected policy error is significant.
David DeRosa through the Bloomberg New York newsroom
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