Greenspan Getting Good Reviews

It is about a year since Alan Greenspan took over as chairman of the Federal Reserve Board from Paul Volcker. What grade does he deserve for his first year, and what does that record tell us to expect from monetary policy in the future?

Greenspan was tested by the stock market crash early in his tenure. He responded to the crash by providing immediate liquidity to the financial system and, subsequently, letting interest rates fall to cushion the economy against possible economic weakness in the aftermath of the market crash. On both counts, Greenspan deserves good marks.

By spring, recession fears had receded. The stock market crash proved to have less effect on business and consumer spending than many had feared, and the low level of the dollar kept our exports booming. Together, these foreign and domestic demands led to strong gains in gross national product, industrial production, and employment in the first half of this year. In part because of this strong expansion, which has reduced unemployment rates and raised industrial capacity utilization, inflation has replaced recession as the main worry of some analysts. For its part, the Fed has tightened its policy during this period, bringing short-term interest rates above their levels of last summer.

Because this is a presidential election year and all the present members of the Fed’s board of governors have been appointed by President Reagan, it was thought that they might bend policy so as to help the Republicans in November. An impartial verdict has to be “not guilty.”

The policy variations just discussed followed the traditional pattern of “leaning against the wind”--lowering interest rates when the risk of a weakening economy emerged, as it did last fall, and raising them when the economic expansion looked exceptionally strong and inflation risks increased, as they have since then. Greenspan’s Fed has not moved interest rates as far, in either direction, as some critics would have wanted. But the critics have thus far been proven wrong. The expansion is healthy, and inflation has not been reignited. Even with hindsight, it would be hard to fault the Fed’s performance.

The next 12 months may bring harder choices for Greenspan and his colleagues. It now appears that GNP growth in the third quarter of this year will be at least as fast as it was in the first two quarters.

Although some current indicators point to slower expansion later in the year, the evidence is not convincing. If the expansion does not slow, the Fed will raise interest rates further, leaning harder against a still-strong wind. If inflation finally begins to re-emerge, its mandate to raise rates will be even stronger.

There will be reasonable differences of opinion about how soon and how severely the Fed should tighten its policy. Some would worry about inflation to the exclusion of all other goals and raise rates sharply and soon. Others would emphasize economic expansion and wait before tightening policy any further on the grounds that inflation is only an uncertain forecast, not a present reality. The Greenspan Fed will place a high priority on inflation fighting and will be inclined to raise rates sooner rather than later.

However, judging from its performance thus far, it will move gradually, testing whether it has done enough before doing more.

There are good reasons for adopting a gradualist approach, including the fact that both forecasting the economy and gauging the impact of any interest rate increase on that forecast cannot be done with great precision. Apart from such business cycle uncertainty, the Fed is aware that higher interest rates have important side effects, most of which are bad.

One problem could appear from the dollar’s exchange rate, which is sensitive to interest rates here and abroad. The rally in the dollar that was pursued by policy makers earlier this year may prove to be too much of a good thing.

There has already been concerted intervention by central banks to keep the dollar from rising further against European currencies, but so far it is hard to judge if this has been sufficient.

Higher U.S. interest rates would make a continued rise in the dollar more likely. And too strong a dollar now could lead to a bigger dollar decline down the road, creating an instability that we would prefer to avoid. A deeper problem with higher rates is their effect on debt burdens and the stability of financial institutions. Under President Reagan, interest expense has been the fastest-growing item in the federal budget, and higher interest rates would add to the already excessive budget deficit.

Even more important, higher rates would worsen the problems of banks and thrifts with questionable debts on their books and would raise bankruptcies among non-financial corporations that have greatly increased their indebtedness in recent years.

The best response to these emerging conditions is beyond the reach of the Fed alone. If the next President acts promptly to reduce the budget deficit, we could hope to head off a renewed inflation without resort to higher interest rates. With decisive budget action, rates could even fall. But only a great optimist can expect that.

After a first year in which he got general applause as well as good marks, Alan Greenspan may find it harder to satisfy everyone in the year ahead, even if he and his Fed colleagues perform as sensibly as they have up to now.