"For monetary policy to foster maximum sustainable economic growth, it is useful to preempt forces of imbalance before they threaten economic stability. But this may not always be possible -- the future at times can be too opaque to penetrate. When we can be preemptive we should be, because modest preemptive actions can obviate the need of more drastic actions at a later date that could destabilize the economy."
Thus spake Chairman
Joint Economic Committee
last week. Two words jumped out at me in the quote above: "preemptive" -- it's baaack -- and "can." The
has downplayed the theme of preemptive action in recent years after having rather pridefully proselytized the idea earlier. Since policy actions are effective only with a lag, the monetary authorities, like duck hunters, have to lead their quarry in order to bag it.
And modest preemptive actions "can" obviate the need for higher doses later. Can, not must, not will, but merely can. Can. Might. Or maybe might not.
The stock and bond markets heard what they wanted to hear in Greenspan's soliloquy and moved higher. But it should be recalled that there has been no braking action yet -- so there is still a lot of money around to move markets. There has been very little headway made in either of these asset classes over the past three months -- quite the opposite in the case of bonds -- so they were overdue to draw solace wherever they could find it. More than any other factor, it has been a developing dread about Fed action that has stunted the returns to stocks and bonds since March, so it was a relief to hear that "modest" actions can get the job done.
But I was reminded of the monetarist catechism as rendered by
. He held that humans just aren't smart enough to be able to forecast accurately enough often enough to justify activist management of monetary policy. As the
of monetary economics, Friedman counseled that Fed policy should be set on automatic pilot in order to minimize the chance that mistaken forecasts would lead to pro-cyclical moves. If the Fed tightens now because it sees a risk of overheating, and that tightening takes effect in six to nine months, but by then the economy has weakened on its own because the Fed saw something that wasn't there¿ well, you get the picture.
For the past year at least, the Fed policy line has been that it isn't quite sure enough of how the world works to feel confident about leading the duck. "The failure of economic models based on history to anticipate the acceleration in productivity contributed to the recent persistent underprediction of economic growth and overprediction of inflation." But now, with "preemptive" back in his lexicon, we can infer that Greenspan is once again ready to swing the barrel and squeeze the trigger.
He displayed his grasp of economic analysis with some math that even Congress could understand. "Overall economic growth during the past three years has averaged 4% annually, of which 2 percentage points reflected increased productivity and about 1 point the growth in our working age population. The remainder was drawn from the ever decreasing pool of available job seekers without work." (It adds up: I checked.) Now we know he's very much pro-productivity, so he doesn't want 2 percentage points to go away, and his office is powerless to do much about our growing up and growing old. So he is left to focus only on that last percentage point if he intends to influence the overall growth rate.
"That last¿ represents an unsustainable trend that has been produced by an inclination of households and firms to increase their spending on goods and services beyond the gains in their income from production. That propensity to spend, in turn, has been spurred by the rise in equity and home prices, which our analysis suggests can account for at least 1 percentage point of GDP growth over the past three years." Ergo, get rid of the rise in equity and home prices and get rid of the "unsustainable" shrinkage in the unemployment rate? Well, maybe the math is not quite that simple, but the Chairman's rendition tempts one in that direction.
He is not going to go after stocks and houses directly because "to spot a bubble in advance requires a judgment that hundreds of thousands of informed investors have it all wrong." But he is not intimidated by the risks inherent in popping a bubble: "While bubbles that burst are scarcely benign, the consequences need not be catastrophic for the economy." He argued that the hard times that followed the 1929 market peak in the U.S. and the 1989 top in Japan were the result not of the markets topping out but of badly managed economic policies in their wakes. No such problems resulted in the U.S. following the 1987 crash -- and he modestly refrained from mentioning that he was on the job in that instance. The conclusion to draw is that Greenspan is not afraid of causing a crash because he knows how to handle a dustpan.
So to "preempt the forces of imbalance" before they can destabilize the economy, he and his colleagues will tap the brakes to cause momentum to decelerate to a pace that can be sustained within the parameters set by natural labor force growth plus productivity. But pressing the brake pedal is not effective if the brake lines have been cut or the brake fluid has drained away; it's not the pedal, it's the brake pads that exert a drag on momentum.
The Fed's braking effect comes not directly but through the markets. If the Fed tightens and interest rates go
and stock prices go
, how will that depress "the propensity to spend?" It won't. So the Fed will press the pedal again. And again. And again. Whatever it takes to be effective. The hunter leads the duck until the duck gets the message.
Jim Griffin is the chief strategist at Aeltus Investment Management in Hartford, Conn. His commentary on the financial markets is based upon information thought to be reliable and is not meant as investment advice. Aeltus manages institutional investment accounts and acts as adviser to the Aetna Mutual Funds. While Griffin cannot provide investment advice or recommendations, he invites you to comment on his column at