VIEW FROM WASHINGTON / JAMES RISEN : Fed’s Greenspan Waging a Battle That Doesn’t Need to Be Fought
Is Alan Greenspan, America’s economic general, fighting the last war?
Increasingly, economists suspect the answer may be yes.
Indeed, there are some intriguing new signals coming from the nation’s economy that suggest that Federal Reserve Board Chairman Greenspan and his colleagues are foolishly waging a battle that doesn’t need to be fought anymore.
For nearly two years, the Fed has single-mindedly pursued an aggressive strategy designed to slow the rapid pace of economic growth in order to avoid an inflationary surge.
An overheated economy, the Fed has fretted, would mean that workers would be in short supply. Labor shortages would lead to higher wages, and higher wages would bring on higher prices. Inflation, the be ^ te noir of central bankers, would give America the illusion of growth, rather than the real thing.
Better, Greenspan has argued, for the Fed to mount a preemptive strike by raising interest rates long before inflation rears its head. Higher rates would cool off the economy, and a slower economy would mean less potential for rising prices. After all, Greenspan has often pointed out, history is littered with reminders of just how hard it is to root out inflation once it gets going.
That, at least, was the thinking that led Greenspan in February, 1994, to launch a no-holds-barred campaign against inflation before there was any evidence of it on the horizon. Eighteen months later, as signs of economic weakness began to spread, Greenspan briefly relented with a slight rate cut of one quarter of a percentage point, but the Fed remains vigilant in its pursuit of price stability, and has refused to cut rates further since July.
But it turns out that the Fed’s calculation of just when the economy became overheated was based on a very faulty assumption. The Fed’s economic thermometer is something called the “natural rate of unemployment.” Now, there are plenty of economists who think that thermometer is miscalibrated.
The natural rate of unemployment--the “NARU” in economic jargon--is supposed to be the lowest rate of unemployment that can be sustained without generating inflationary pressures on the economy. When Greenspan launched his preemptive strike, the thinking at the Fed was that the natural rate of unemployment was around 6%. Lawrence Lindsey, a conservative member of the Fed’s board of governors, even suggested that the natural rate might be as high as 6.4%. But there was general agreement within the Fed that if the jobless rate fell much below the 6% mark, prices would eventually start to rise.
Surprise! Greenspan and the experts were wrong. The economy has proven more resilient in the face of the Fed’s interest rate hikes than anyone anticipated--the nation’s jobless rate has remained below 6% for 14 straight months, falling to 5.5% in October.
Yet there is virtually no sign of inflation anywhere. In fact, the inflation rate has been coming down this year, not going up. During the 12 months that ended in September, the consumer price index averaged a 2.5% rate of growth, compared to 2.7% for 1994.
What happened to the gloomy predictions that the economy couldn’t manage both lower unemployment and faster job growth? “We now see that the idea that the natural rate was 6% was a myth,” says Allen Sinai, chief economist of Lehman Bros. “Even the advocates of the idea that the natural rate was 6% acknowledge that inflation should show up within a year after we go below 6% unemployment. But inflation hasn’t shown up. Inflation is slowing. Wages are flat.”
“In every business cycle, there are conventional wisdoms that disappear,” adds Sinai. “When the history of this business cycle is written, the myth that will be exposed will be the natural rate of unemployment.”
Even conservative supporters of Fed policies now agree. “If you look at predictions of inflation from the NARU, the predictions are not very good,” says Alan Meltzer, an economist at Carnegie-Mellon University and chairman of the Shadow Open Market Committee, a private group that monitors Fed policies. “As a forecasting tool, it is really not terribly good.”
If anything, the latest data offers a measure of vindication for the Clinton Administration’s economic team, which openly disagreed with the Fed’s estimates of the natural rate of unemployment last year. In the last Economic Report of the President, the White House assumed that the natural rate of unemployment was between 5.5% and 5.8%--figures which were dismissed as “dovish” and “soft on inflation” by economic hard-liners.
“But now it appears that the natural rate is at the low end of our range, or maybe even below the range we used,” says Joseph Stiglitz, chairman of the Council of Economic Advisers.
Don’t think this is some arcane debate among policy wonks without real consequences. If the natural rate is much lower than the Fed ever guessed--or if such a rate doesn’t exist anymore in today’s dynamic, global economy--then Fed policies are all out of whack. If, for instance, the natural rate of unemployment is really around 5.2% instead of 6%, then the Fed’s benchmark interest rate, the federal funds rate, should be around 5% instead of its current level of 5.75%.
“The Fed’s emphasis on the natural rate has occurred at a time when the 6% rate for the NARU is evaporating in front of our eyes,” observes Barry Bosworth, an economist at the Brookings Institution.
How did the Fed get it so wrong?
By looking backward.
In the late 1980s, price pressures did begin to build around the 6% unemployment mark. After the jobless rate fell below the 6% mark and stayed there from 1987 to 1990, hourly compensation for American workers rose sharply. By 1990, hourly compensation was growing at a 5.5% annual pace--up from 3.5% at the beginning of the three-year period. And inflation took off: The consumer price index went from 3.7% to 5.5% during the same three years.
There were plenty of other examples in history that seemed to prove the validity of the natural rate theory. But it seems that economists tried to extrapolate too far from the historical data. They developed a formula that lost its validity as the economy changed.
What’s troubling is the fact that Fed officials have been arrogant enough to think they can attach a specific speed limit to economic growth. That is an extraordinarily pessimistic concept, straight out of Thomas Malthus. It is a dry theory that seems to ignore the potential for transforming events that rearrange the world.
So, you have to wonder: did somebody forget to mention to Greenspan that thing about the Berlin Wall?