Has the Federal Reserve Overdone It? Probably...

J. Bradford DeLong

for Fortune

For nearly a decade Alan Greenspan’s skill—and luck—in setting interest rates has been astonishing. He has navigated the elimination of the federal budget deficit and the computer and communications revolution, adeptly guiding the American economy through an amazing era. But for the first time in a decade there are signs that he may well have misjudged the economy and put us on a course toward a recession.

It has been a long time since anyone talked about the risk of a recession. Save for the blip at the beginning of the ’90s, the American economy has been recession-free since 1983. It has been hard to fault the Federal Reserve for just about anything for nearly two decades. From 1983 to 1987 under Paul Volcker, the Fed guided the economy to a rapid recovery without reigniting the inflation of the 1970s. In the early years of Alan Greenspan’s term it moved aggressively to make sure the stock market crash of 1987 did not raise unemployment. It succeeded. Greenspan correctly decided that the risk of a recession of 1990–91 was preferable to the consequences of widespread joblessness should the 1987 stock market crash cool aggregate demand.

Then came the amazing performance of the 1990s. In the first half of the decade the Fed held down interest rates to make sure that deficit reduction did not depress demand. In the second half it let unemployment rates drift down to 4%, a level that no one thought possible at the start of the decade without rising inflation .

Over the past two years Greenspan, worried that our economy has overheated, has raised interest rates by two percentage points, to 6.25% today. His goal: curbing inflation without sending the economy into a recession. Greenspan’s hikes have certainly slowed the economy. Real GDP grew at a 5% annual rate in the first half of the year; it should grow at about 3% in the second half.

One problem with his recent rate hikes is that they have created one of the standard signs of an approaching recession. The interest rates on ten- and 30-year Treasury bonds are now lower than the interest rate on a three-month Treasury bill; this is an inversion of the normal pattern, in which short-term interest rates are lower than long-term ones. What’s so bad about that? It signals that the economy is slowing quickly.

Here’s an even bigger problem: Job creation has tapered off significantly. In the first half of the year the economy created 1.6 million nonfarm jobs. In the second half of the year it looks as though it will create only 350,000. This trend—in conjunction with the stock market’s plunge—is troublesome because it indicates that the consumer spending that has propelled our growth is likely to subside.

The worst news, however, is that we haven’t yet felt the effect of all of Greenspan’s six hikes. The rule of thumb is that it takes a year (or a little more) for interest rate increases to affect production and income, a little longer to affect employment, and still longer to affect the rate of inflation. About half of the latest round of increases have yet to affect the economy. These factors make a recession in the next two years possible and perhaps even likely.

Sure, it is possible that the underlying strength of economic growth may surprise us again. But that does not seem likely. The Fed’s decision-making by committee creates a tendency to fall behind the economic news. The agency may defer action for a meeting or two to satisfy more cautious members. As former Federal Reserve vice chair Alan Blinder points out in his Central Banking in Theory and Practice, this committee structure prevents the agency from reversing course rapidly. At the moment the Fed is in a tight spot. The newest batch of data suggests that we would be better off if the last two to three interest rate increases had never happened. But lowering interest rates at this point would be a sharp departure from Fed policy. There’s one axiom on which everyone agrees: Financial markets dislike big surprises. If the Fed pulls a fast move, the markets become suspicious that there are more shocks to come.

My take: At this point, we need to sit tight and put our faith in Greenspan’s judgment. I hope I’m wrong and his 13-year old perfect streak is not about to end.

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