Fed’s Dilemmas Expose Limits of Its Influence

Here’s where Alan Greenspan earns his pay.

As chairman of the Federal Reserve Board, Greenspan is confronting one of the trickiest central bank policy conundrums in years.

In short, things have not gone as Greenspan would have hoped over the last six months, in the U.S. economy or in the stock market. And some experts now worry that the Fed is increasingly boxed in by its policies, with little flexibility to respond to any sudden shock to the global economy or financial markets.

The Fed’s frustration--and the frustration of Fed critics--centers on four main issues:

* Greenspan thinks the economy is overheating, but four Fed interest rate increases in the last nine months have yet to cool it down significantly. Central bank policymakers meet again Tuesday, and another rate increase is expected.

* He thinks inflation is about to break out, but he can’t prove it--certainly not to the satisfaction of a critical Congress.

* He frets about speculation in technology stocks, yet many experts say Fed policy now is helping to fuel more speculation rather than dampen it.

* He insists that he is not targeting a certain “correct” level for the stock market, but says the Fed must continue tightening credit until Americans with stock wealth stop feeling as if they can spend that wealth so freely.

Greenspan gets so much credit for the U.S. economy’s record nine-year expansion that he is often referred to as the second most-powerful person in the world, after President Clinton.

But the Fed’s dilemmas today expose the limits of the central bank’s power to direct the economy and influence financial markets.

Perhaps most worrisome, the Fed--by asserting that the threat of inflation is serious, and that the stock market is helping to drive it--now may have little ability to respond with interest rate cuts should global financial markets suffer some sudden shock.

The Fed’s basic tool is the ability to raise or lower the interest rate paid on “federal funds,” or overnight borrowings between banks.

Changes in the fed funds rate, now at 5.75%, directly and indirectly affect the rates that consumers and businesses care about, including those paid on mortgages, credit cards and commercial loans.

The Fed began raising its key rate in June, citing concern that the economy’s strength would soon begin to fan inflation fires, driving up prices and wages at a rapid pace.

Yet the economy has continued to expand briskly, while inflation has remained subdued. Greenspan, meanwhile, has been steadfast that rates must rise until business and consumer spending slows.

To a growing number of Fed critics, however, the Fed has simply made the wrong diagnosis.

“When you look at the world, productivity’s as strong [as] or stronger than ever, inflation is nowhere to be found, jobs are going to people who couldn’t dream of finding them years ago, and yet somehow, they feel they have to fight this prosperity,” said Brian Wesbury, economist at Griffin, Kubik, Stephens & Thompson in Chicago.

All of which helps explain why Greenspan took so much flak from normally reverential members of Congress last month during his economic outlook testimony.

Where’s the fire? the Fed chief was asked. Why risk throttling the economy when he himself admits that inflation is hard to spot anywhere but in gasoline prices? What’s wrong with investors getting rich on tech stocks?

Greenspan’s replies to such questions indicate to some economists that he is straining to develop new theories to explain the baffling circumstances facing him.

In particular, rarely, if ever, has there been so sharp a divide between the “haves” and “have-nots” of the stock market.

The Fed’s current campaign of interest rate increases has pummeled stocks representing the “old economy”--consumer goods, banks, drugs, airlines, chemicals. So far this year, the Dow Jones industrial average is down 15%.

But “new-economy” stocks--wireless phones, computer chips, the Internet--have continued to rocket. Even as the Fed pushed uprates, the Nasdaq Stock Market composite index, driven by tech names, soared 86% last year and is up nearly 16% this year, despite a sell-off in recent days.

“Raising interest rates raises the cost of doing business mainly for old-economy companies,” said Deutsche Bank economist Edward Yardeni. Many tech companies, on the other hand, don’t need bank loans; as long as Wall Street keeps panting for their shares, they have easy access to cheap capital.

What’s more, the market split has fed on itself: When old-line firms such as Procter & Gamble confess that earnings growth is being squeezed, investors dump them and pour ever more cash into the fast-growing tech names that have defied the Fed.

Contrast the market reaction with what happened the last time the central bank was raising rates, in 1994. The market followed the Fed’s script, declining across the board. The Nasdaq index in that year fell 3.2%.

Perhaps, with the Nasdaq index dropping 7% in the last two days, the long-expected tech-stock correction has finally begun. Yet investors lately have shown determination to pile back into technology after every pullback.

Greenspan’s problem with the market’s failure to obey the rules is that higher stock prices drive the “wealth effect,” which is peoples’ propensity to spend some of their stock gains, adding more fuel to the economic fire.

Greenspan has raised eyebrows by repeatedly mentioning the wealth effect.

However, other respected economists feel that the wealth effect plays a far smaller role than Greenspan has implied. Some deny even the existence of a wealth effect.

Economist Gregory D. Hess of Oberlin College supports the Fed’s preemptive strikes against inflation, but feels the emphasis on the stock market, and the wealth effect, violates a long-standing principle of Fed statecraft. The Fed, he said, should never allow the public to think its actions are tied to any particular indicator--the Nasdaq index, for example.

To be sure, some Fed-watchers say the central bank may not be in a serious jam after all--assuming the economy begins to slow soon.

Things don’t look as dire as in, say, the mid-1970s, when the Fed confronted “stagflation”--roaring inflation coupled with anemic economic growth. At that time, the central bank’s aggressive rate hikes finally did snuff out inflation, but at the cost of a severe recession.

Today, recession seems a remote worry. Even so, the Fed’s interest rate stance, and emphasis on reining in the stock market, has many experts concerned about the loss of flexibility should an unexpected shock occur.

In the fall of 1998, a Russian bond default and financial crises in Asia and Latin America had the U.S. stock market on the edge of panic. The Fed responded with three quick rate cuts, calming the markets.

Likewise, the Fed intervened immediated after the stock market crash of 1987.

This time, it wouldn’t be so easy for the FED to justify helping if markets were to dive from some sudden shock. And that could raise the risk of a cascading market decline that coould ultimately have severe consequences for the economy.

Even without a sudden shock, the Fed risks driving old-line companies, and stocks, into deeper holes if interest-rate policy remains aimed at bringing down the most speculative stocks. What’s more, the higher the tech stocks go, the harder they may fall if the bubble bursts abruptly.

“Greenspan is in a box in this sense: If there is a real crash in the stock market and he’s inclined to do what he did in 1987, he’s hamstrung by the fact that further liquidity increases are counter to what he wants to achieve,” said Anna J. Schwartz, a veteran Fed watcher at the National Bureau of Economic Research.