greenspan is sure self-sustaining recovery won't need cheap money
July 25, 2004
For those who thought the Federal Reserve would use June's "soft patch" in the US economy as an excuse to hold interest rates steady, chairman Alan Greenspan set them straight this week in his semi-annual monetary policy report to the US congress.
While there were risks involved in the "transition to a more neutral stance of monetary policy", those risks were "outweighed ... by those that would be associated with maintaining the existing degree of monetary policy accommodation in the current environment", Greenspan told the senate banking committee.
It was the first time Greenspan had been emphatic about the balance of risks associated with holding the federal funds rate below the rate of inflation in an expanding economy.
That he buried his lead in the penultimate paragraph owes more to his immediate audience than his intended message.
That message was clear:
The expansion has become self-sustaining;
Rising employment will augment disposable income and bolster consumer spending; and
Under the circumstances, "the considerable monetary accommodation put in place starting in 2001 is becoming increasingly unnecessary".
So there you have it. There will be no detour on the road to higher interest rates next month. That reality was immediately reflected in short-term interest rate futures markets.
The implied yield on the March eurodollar futures contract, which had fallen 60 basis points in the past month to reflect a more "measured" pace of rate increases, rose 13 basis points on Tuesday.
Greenspan was less clear on the subject of inflation than he was in his assessment that the economy's soft patch would be "short-lived".
After reiterating his view that inflation in the first half of this year was "boosted by transitory factors, such as the surge in oil prices", Greenspan launched into a discussion of his new anti-inflation weapon: profit margins.
In the past year, all of the price rises in finished goods and services produced by non-financial corporations "can be attributed to a rise in profit margins rather than rising cost pressures", Greenspan said.
In fact, unit costs declined, he said. Because profits as a share of total income are historically high, that suggests to Greenspan the growth of profits will slow relative to the growth of costs.
He may be right. But that has nothing to do with inflation.
"He leaves out an important part of the equation: what happens to prices," said Bob Laurent, a professor of economics and finance at the Illinois Institute of Technology. "Prices aren't determined by what happens to costs. If they were, why would companies ever lose money?"
Prices were determined by demand, Laurent said. If demand was strong enough, prices could rise even as the profit share stayed the same.
"Why are all these central banks talking about being vigilant against inflation if profit margins are above average?" Laurent asked.
This is not the first time Greenspan has offered up profits as insurance against inflation.
"It's interesting to watch him dig through the entrails of the cost structure to assure himself that [the rise in] inflation is a temporary phenomenon," said Jim Glassman, a senior US economist at JP Morgan Chase.
In Greenspan's world, if the rise in prices "is a short-term demand phenomenon, it's more benign than if it's due to a ratcheting up of costs", Glassman said.
Inflation is always a demand phenomenon. Rising costs are just another manifestation of too much money chasing too few goods and services.
Greenspan has said that without a rise in labour costs, the single biggest input to prices, inflation couldn't accelerate.
"This almost exclusive focus on labour costs as a driver of inflation is flawed as it lacks solid theoretical and empirical support," said Joachim Fels, a senior economist at Morgan Stanley in London. "Essentially, it rests on a simple Keynesian model where companies set prices as a mark-up over costs."
That was not the way companies operated, Fels said.
"Companies set prices in response to specific characteristics of the markets in which they operate. They react to general demand conditions, the degree of competition, product differentiation, shifts in tastes and many other factors on the demand side."
Rather than determining prices, labour costs "determine where a company invests and produces in a globalised world", Fels said.
But Greenspan acknowledged (also in the penultimate paragraph of his testimony) that inflation in the long run was a monetary phenomenon - and therefore his responsibility. - Bloomberg
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