Can Mr. Greenspan Have His Cake And Eat It Too?
As expected, the Fed
left the funds rate rate unchanged at 1.25% yesterday. However, the
markets, as well as I, were caught off guard by the FOMC’s new directive–not
because the Fed adopted a bias toward easing, but because the committee has
decided to target inflation and economic growth separately.
By stating that “the probability of an
unwelcome substantial fall in inflation, though minor, exceeds that of a pickup
in inflation from its already low level.” while simultaneously saying that it is
comfortable that current factors “should foster an improving economic climate
over time”, the Fed is telling the markets that it intends to keep
interest rates low during the initial phase of the economic pickup. This is
important to know because if the markets believed that the Fed was about to
embark on a tightening cycle (which is typically what happens when the economy
picks up steam), interest rates could shoot up dramatically from their unusually
low levels, cutting off the source of cheap financing that is currently
available to consumers (via low mortgages) and businesses (via low cost of
capital). And if this source of liquidity were to dry up, the economy would
undoubtedly go right back into a recession. But because of the unusual economic
circumstance, where the prices of certain goods–not all–are declining and the
economy is gradually improving, Mr. Greenspan can have his cake and eat it too.
In my view, barring some exogenous catastrophe in
the months ahead, it is unlikely that the Fed will actually lower interest rates
any further. Instead, it will continue to use rhetoric to “talk down” interest
rates without actually cutting them while the economy and the stock market move
higher.