Greenspan must be sensitive to growth uncertainty -
Comment in the FT by Professor Stephen Cecchetti

Published in the Financial Times on September 19, 2005

Stephen Cecchetti Professor at the Brandeis International Business School

A month ago, the US economy looked to be on course. Inflation was edging up but still well within Federal Reserve policymakers' comfort range. With real growth steady at just above 3½ per cent, output was near its target level as well. Then the storm hit. With Hurricane Katrina came not only loss of life and destruction of property but a significant increase in uncertainty.

While the Federal Open Market Committee is poised to raise interest rates at its meeting on Tuesday, it is now hard to say what the autumn will bring. What will be the impact of recent energy price increases on the national economy? Will consumer confidence hold up? And what about the property price bubble? In the past, these sorts of uncertainties have led Alan Greenspan and his colleagues to ease, not tighten policy. Today, that means pausing to wait for more information.

Among Mr Greenspan's most significant accomplishments is his success in transforming central bankers into the risk managers of the economic and financial system. This means that, first and foremost, monetary policymakers make sure nothing really bad happens. For example, when faced with the very real possibility of deflation in June 2003, the FOMC reduced its target federal funds rate to 1 per cent and kept it there for a full year. The small risk of a severe economic collapse elicited a very forceful policy response.

Another hallmark of Mr Greenspan's tenure at the Fed has been gradualism. The biggest interest rate move has been 0.5 percentage point and a more typical change has been half that. By moving in a series of small steps, policymakers keep their options open.

Returning to the present circumstance, it now appears that Katrina's impact on the national US economy will be relatively small. Oil prices have returned to their pre-storm level and transport bottlenecks are disappearing.

Nevertheless, there are significant risks left for the Fed to manage. First, it seems almost certain that the dramatic increase in energy prices over the past year will finally eat into non-energy household consumption. American petrol prices have risen from just over $2 a gallon in early July to $3 a gallon today. The rule of thumb is that a one cent increase takes about $1bn out of disposable income. With households saving a mere $25bn out of $10,300bn in income, it is impossible to see how Americans can absorb this $100bn increase in fuel costs without reducing consumption. Rising winter heating bills will make matters worse.

This brings us to the second risk: that the recent decline in consumer confidence will be sustained. When people lose faith in the future strength of the economy, their pessimism can be self-fulfilling. Fearing calamity, they might increase their saving and drive down current consumption. While good in the longer term, in the short run such a move will slow aggregate economic activity.

With housing, the Fed has been walking a tightrope for some time. It is no exaggeration to say that the past three years of American prosperity have been supported by the housing boom. While it is hard to predict what might trigger a correction, the consensus is that one will eventually come. The only hope is that when prices start to fall, the slide will be gradual. And when the boom ends, consumption growth will surely slow.

The right policy response to all this is very tricky. Considering energy price increases in isolation would imply raising interest rates to combat incipient inflationary pressure. Adding the fiscal stimulus that the US Congress is enacting to rebuild New Orleans and the Gulf coast provides a further case for tighter monetary policy.

Before Hurricane Katrina, the risks were primarily on the inflation side. Now, the biggest question mark is growth, so a pause in the steady upward march of interest rates would make sense. In fact, the logic of Mr Greenspan's risk management approach demands it. After all, an increase in uncertainty means the odds of a bad growth outcome have gone up. Since inflation is not an immediate concern, that means keeping interest rates low.

Not only are higher interest rates imprudent in the current economic environment but by raising them the Fed also runs the risk of appearing callous. So, while the pause is not coming this week, Mr Greenspan and his colleagues must strike an uncharacteristically conciliatory tone in their coming public statements. This will prepare everyone for the possibility that their interest rate target will not change when they meet on November 1. Good risk management demands it.

Stephen G. Cecchetti is Professor of International Economics and Finance, Brandeis University, and Research Associate, National Bureau of Economic Research. He is a regular contributor to the Financial Times.