Greenspan to Walk Tightrope

Aaron Pressman

Haste still pays haste, and leisure answers leisure; Like doth quit like, and measure still for measure. --
Shakespeare's Measure for Measure

Time is running out on Alan Greenspan, the long-serving chairman of the Federal Reserve. Expected to retire in just under a year when his term to the Fed's Board of Governors runs out, the maestro's legacy, if he departed today, would be one of responsible stewardship of monetary policy and of a chairman who helped the economy weather a series of crises without a major crash.

But there's still one challenge left for Greenspan -- orchestrating the unwinding of the massive stimulus put in place after the Internet bubble popped and terrorists attacked on 9/11. Having kept inflation-adjusted, or real, short-term interest rates in negative territory for more than three years, the chairman and his colleagues are now moving to bring rates back to normalcy as soon as possible.

Whether they can do so without igniting a crisis in any of the pockets of speculation and "excessive risk taking" they have created, brings to mind William Shakespeare's line that haste still pays haste. Or in this case, perhaps, leverage still pays leverage and the carry trade answers the carry trade.

Still, at least so far, the task is going smoothly. At each of six consecutive meetings, the Fed's Open Market Committee has raised rates by 25 basis points to bring the fed funds rate up to 2.5%, from 1% last spring. And the economy has continued to expand, labor markets have improved somewhat and inflation has remained tame.

All of that has helped form a vast consensus that the Fed can, in its own words, remove its accommodative policy "at a pace that is likely to be measured" without disrupting the economy or causing huge losses in the sectors that have benefited most from low rates, such as real estate, emerging market equities and junk bonds.

Return to Normalcy

As Greenspan takes the stage on Wednesday to deliver the first of his semiannual congressional testimonies on the state of the economy, investors will be looking for signals as to the next phase of the return to normalcy. The consensus crowd thinks he may hint that the schedule of rate hikes is headed for a pause, aka the 'Goldilocks scenario.' Meanwhile, a minority of economic bears and Cassandras see the possibility of more hikes than the market anticipates.

"The market is still essentially priced for the Fed to be on hold from midyear, and the extent to which this view is confirmed or refuted by the Chairman's remarks will probably be a key determinant of whether the current rock-bottom level of intermediate- and longer-term rates is sustainable," Morgan Stanley analysts Ted Wieseman and David Greenlaw noted on Monday.

Given the strength of the current consensus and the modest rate hikes anticipated in the futures markets, the analysts preach caution.

"The greater risk to the market from the testimony would certainly seem to be a relatively more hawkish message from Chairman Greenspan," Wieseman and Greenlaw add.

But most commentators are expecting much less.

Larry Horwitz, senior industry economist at Decision Economics, predicts little news, at least on monetary policy, at the hearing. "The Fed is apparently comfortable with the near-term path of inflation and the real economy," Horwitz wrote. If any news is to be forthcoming, it likely would be on other topics raised by members of Congress during Q&A, when Greenspan's answers can be "quite illuminating and occasionally surprising," he noted.

Last time Greenspan showed up for the testimony formerly known as Humphrey Hawkins, back on July 20, he didn't make many waves, consistent with Horwitz's predictions for the upcoming session.

Economic conditions appeared "quite favorable" and inflation was growing but not threatening, Greenspan said in his testimony. The Fed already had signaled in the statement after its May 2004 meeting that it was planning to start raising rates soon, so the big news already was out of the bag. The S&P 500 finished the day at 1108.67, up just 0.7%.

Bonds sold off a bit and the yield on the 10-year Treasury note rose from 4.36% to 4.45%. Greenspan prompted the weakness when he dismissed worries from the spring that deflation might force the Fed to take dramatic action, even by entering the market to buy Treasuries.

"Concerns about the remote possibility of deflation that had been critical in the deliberations of the Federal Open Market Committee last year can now be safely set aside," he said.

It was hardly a huge move, however. The 9-basis-point increase seen last July is exactly the average change in the 10-year's yield on the first day of Greenspan's congressional testimony over the past five years, according to research by Lehman Brothers.

Perhaps this year, Greenspan will revisit his predictions that the dollar can safely lose value, the real estate market can safely decelerate and the trade deficit can safely shrink. But it's not likely.

Instead, he will, like the villain of Measure for Measure, Angelo, seek to avoid the worst consequences. First condemned to the chopping block, he is pardoned in the end.

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