Anatomy of a Rate Hike : How Greenspan Got the Fed to Change Course

The furor over interest rate increases by the Federal Reserve Board underscores a stark fact of life in the nation’s capital: Fed Chairman Alan Greenspan is the most powerful Republican in Washington and, for the Clinton Administration, perhaps the most dangerous conservative in town.

A reconstruction of events leading up to the recent string of interest rate hikes illustrates Greenspan’s ability to carry out a conservative, Republican-influenced monetary policy without running afoul of a relatively liberal Democratic Administration.

A key element in that strategy, according to insiders who discussed the fundamental monetary policy shift by the nation’s central bank, is Greenspan’s ability to avoid internal conflicts that might weaken his credibility with the White House and Congress.

In interviews, Fed officials said they realized the turning point had arrived as they gathered at Washington’s Watergate Hotel for a traditional round of dinner and drinks on the eve of a critical Feb. 4 meeting of the rate-setting Federal Open Market Committee.

Thanks to Greenspan, the Fed had accommodated the Clinton White House throughout 1993 by keeping interest rates near historic lows while the nation’s economy picked up speed. Every time a Fed official suggested that the central bank should start raising interest rates to keep inflation in check, Greenspan argued against it. And every time, Greenspan prevailed.

“The chairman just wasn’t ready last year,” said one senior official who, like others, discussed the Fed’s inner workings on condition of anonymity.

“The chairman is more cautious than some others on the Open Market Committee because he doesn’t want to have to change his position later,” a Fed source said. “He doesn’t like premature moves or having to reverse himself. And as a result, he has never had to reverse himself on a monetary policy move.”

By early 1994, however, Greenspan had convinced himself the time had come to change course. At the dinner on the night of Feb. 3, it was understood that the long-awaited policy turn would come the next day.

“It was clear before the meeting that we were on the brink,” recalled one source.

Greenspan was determined to get all the members of the Open Market Committee to endorse what would be the first interest rate increase imposed by the Fed in five years. A split vote, he feared, would signal to outsiders a lack of consensus within the central bank.

By happy coincidence, at least for Greenspan, the Labor Department reported on the morning of Feb. 4 that the economy had created far more jobs in January than analysts had expected. Fast job growth meant only one thing to Fed officials: Inflationary pressures would soon begin building unless the Fed acted quickly to hit the brakes.

“What had been a minority view--that the recovery was strong and sustainable--now was the mainstream consensus,” a Fed official said.

Greenspan got the unanimous vote he was seeking to raise the benchmark federal funds interest rate to 3.25% from 3.00%. In fact, he had to rein in some committee members who wanted to approve a larger rate hike of half a percentage point. He convinced them that a half-point raise would give too much of a jolt to the nation’s financial markets.

Still, when Greenspan took the unprecedented step of publicly announcing that first rate hike on Feb. 4, he and his colleagues were stunned by the reaction: a 96-point plunge in the Dow Jones industrial average.

“We knew we would see a correction in the markets, but we were surprised by the scale of the reaction,” a Fed source said.

Fed officials were especially troubled that long-term interest rates, which are determined by market forces, have risen more rapidly than the short-term rates controlled by the Fed. In theory, long rates should have risen by a lesser amount if traders thought the Fed was moving aggressively enough to restrain future inflation.

More significantly, the policy shift proved far less popular among the nation’s political leaders and opinion setters than Greenspan had anticipated. There was no evidence that prices had begun rising, the outsiders said, and so the rate hikes seemed premature.

Greenspan and other Fed officials believe that complaint is irrelevant. The Fed, they argue, must act on the basis of where it thinks the economy will be 12 to 18 months in the future. They believe rate hikes do not produce their full effects on the economy until then.

By that time, Greenspan and other Fed officials believe, there will be plenty of evidence of rising prices--or at least there would be if the Fed failed to act. Consequently, the Fed raised rates a second time in March and a third time in April.

Fed officials express confidence in what they have done. “In hindsight, we were all surprised by the strength of the market reaction, but I’m sure our moves have been correct,” one senior Fed source said.

Meanwhile, Greenspan has developed good rapport with Treasury Secretary Lloyd Bentsen. The two meet at least once a week and shared private breakfasts twice last week. The alliance could help insulate Greenspan if tensions mount between the Fed and the Administration as rates continue to rise.

Bentsen recently said he expects the federal funds rate to reach 4.00% from its current level of 3.75%. That remark seemed to signal the Administration’s willingness to accept at least one more quarter-point increase.

In addition, insiders say the White House quietly sought Greenspan’s opinion about Clinton’s candidates to fill two vacancies on the Fed’s seven-member board of governors before nominating Alan Blinder and Janet Yellin for the seats.

While Blinder now seems to be the favorite to succeed Greenspan, some White House officials say Clinton has not ruled out reappointing Greenspan for a third term as chairman when his current term expires in March, 1996.