Coming Up, a Big Week for Greenspan
Jude Wanniski
February 16, 1994


As the debate swirls through the financial markets and political circles regarding the Fed's tightening, Chairman Alan Greenspan is bracing himself for his appearances next week before the House and Senate Banking Committees. As he writes his testimony in his second-floor office at 20th and C Street in the old Fed building, he can see Capitol Hill in the distance, and he can almost hear Chairman Donald Riegle of Senate Banking and Chairman Henry Gonzalez of House Banking sharpening their knives. Why, they will ask, did he tighten, against their expressed wishes, with no signs of inflation on the horizon, much less the midground? And how does he explain the fact that the financial markets greeted the move with clear contempt, what we used to call a Bronx cheer? The blue chip Dow Jones average took its biggest fall in two years and, what's worse, the bond market continued its slide. What's Greenspan going to say?

The most prominent arguments put forward on either side of the debate since the Fed move two weeks ago offer him little assistance. But it is important that they be understood and that Greenspan be prepared to handle them. From the Keynesians, we got The New York Times essay of John K's son, James K. Galbraith, February 8, "The Fed Goes for Overkill." From the monetarists, we got The Wall Street Journal article of Allan Meltzer February 9, "Still Too Easy." From the technicians, we got Randall W. Forsyth's February 14 report in Barron's, "Tightening's Impact: What History Teaches," probably the most important of the conventional attacks against the Fed move. Our position was represented in Robert Novak's February 10 column in the New York Post, "Fed's Miscue," which centers on the arguments of Wayne Angell, whose eight years as Fed governor ended the previous day. The only other really important piece that has appeared in public print is in today's NYTimes as a letter to the editor, by the eminent Geoffrey H. Moore of Columbia University, "Forecast Warns of Inflation Clouds," which challenges the Galbraith arguments of February 8.

The Galbraith argument makes the Keynesian case, popular with Senators Riegle and Paul Sarbanes: What is the justification for the quarter-point rise in the fed funds rate? "The stunning fact: There is none. [Greenspan] warned for months about the threat of rising inflation, yet each monthly price index report undercut his predictions. So now we have a preemptive strike -- a rise in rates to forestall an inflationary threat that all agree has not appeared." Galbraith chastises President Clinton for going along with Greenspan's needless "preemptive strike." As he put it: "Confronted with this brazen act by the Fed, President Clinton wounds himself by seeming to welcome it." 

The Meltzer piece, appearing the following day, contradicts the Galbraith assertion that "all agree" there is no inflationary threat. On the surface, it seems like a defense of Greenspan, in that he argues that the Fed did not go far enough. This is Milton Friedman in sheep's clothing, though, as Professor Meltzer builds his analysis on the rapid growth of the monetary base. Greenspan, Angell and the other Fed governors have spent the last three years trying to drive a stake through the heart of these monetary aggregate rules -- which were at the heart of the great inflation of the last 20 years and which destroyed both the Nixon and Carter presidencies. Indeed, Greenspan would have to reject Meltzer's reasoning or find the monetarists on the Banking Committee staff trapping him with the broader monetary aggregates, all of which might suggest the Fed has been too tight. It has been the practice of the monetarists to shift from the monetary base to M1 to M2 to M3, depending on which indicator supports their theorems at any given time. 

Randy Forsyth of Barron's, the best of the bondwriters, takes us through the history of the last several Fed tightenings going back to 1958, in support of his thesis that they are always bad for bonds: "History shows that the Fed never tightens just once, and that, despite current conventional wisdom, it's never good for bonds." Insofar as Greenspan seems to have the green light from the White House to tighten by as much as 75 more basis points during the course of the year, this would seem to be very bad news for bonds. The Forsyth argument, though, lacks internal logic, as it suggests the bond market would respond positively to a perpetual easing of monetary policy by the Fed. It's theoretically possible that bonds would respond positively 9 times out of 10 or even 99 out of 100, but somewhere along the line they have to respond negatively to ease and positively to tightening, or the nation's creditors have to be an aggregation of simpletons, happy as clams holding depreciating assets.

In an ideal monetary world, assuming the nation's creditors are, in aggregate, as sharp as tacks, a Fed tightening would always be followed in the first instance by a rise in bond prices. And, if the Fed believed incipient deflation was the problem, a Fed ease would be followed in the first instance with a rise in bond prices. For most of the history of the Federal Reserve, going back to 1913, this was indeed the case; but the easings and tightenings were so microscopic, it would take Barron's a few years of digging into the records to find them. This is because they were automatically adjusting to liquidity preferences on a daily basis to keep the price of gold at $20.67/ounce, dead on, until 1934, and at $35/ounce, into the late 1960s, when the Fed began caving in to political pressures to devalue the currency, to inflate. In each instance, the indices of statistical inflation were preceded by a rise in the price of gold or a gold outflow to Europe.

This thinking was behind the Novak column: "Angell, off the government payroll this week after eight years on the Board of Governors, did not participate in the Feb. 4 decision. He wanted rates increased twice as much and much earlier. His reason: the rising price of gold, signaling inflation ahead." That is, if Greenspan had followed the advice of Angell last year before gold advanced by 10% above the $350 level, it would have taken only one small tightening to rein it in. Now, he believes, if the Fed were to tighten just once, confounding the Forsyth analysis, it should have been a 50 basis point move, accompanied by an explanation from Greenspan that his concern is gold's inflationary signal. This is pretty much our view, but that's history. What now?

Which brings us to this morning's letter in the Times from Professor Moore, who cites a basket of signals that have emerged since January 1 indicating an inflation on the horizon -- led by commodity price inflation, but also including a rising percentage of purchasing managers reporting higher prices, managers reporting slower deliveries, a rising percentage of businessmen expecting higher sale prices in the last quarter, the ratio of employment to population heading up, and likewise with import prices. His inflation index at Columbia University's Center for International Business Cycle Research "rose sharply last month and is growing at its fastest pace in eight years. Therefore, it is fallacious for Professor Galbraith to maintain that there is no justification for the Fed's minuscule rise in interest rates. There are early warning signs of a cyclical upswing in inflation."

Now, there is more Phillips Curve thinking in this argument than I like. "Inflation is not caused by too many people working," as Margaret Bush Wilson of the NAACP put it a dozen years ago. It does, though, give Alan Greenspan great comfort, I'm sure, as he prepares for those sharpened knives. But just as he cannot lean on Professor Meltzer's fallacious argument for support, he has to find a way to downplay Moore's cyclical arguments, which may be correct in a narrow sense, but only get the bondholders mixed up. In other words, Greenspan tried in his Joint Economic Committee testimony of January 31 to explain that he would not tighten to slow economic growth, only to anticipate inflation. That's not how the tightening was reported four days later. Next week, he either has to develop his arguments further, or be coaxed into that process by the committee members. The nation's creditors cannot afford to reward him with a bond market rally unless he gets it right.

He'll never have quite the same chance that he'll have next week. The White House is in the process of picking nominees for the two vacancies at the Fed. The markets will assume the pick for Vice Chairman will move up to the chairmanship in 1996. If it is someone like Bob Rubin, with experience on the market firing line, it would keep things clear. If it is an academic, we will all have to assume the waters will muddy up, and Greenspan will have less opportunity to educate the markets on his deep-down thinking. It's a big week for him.