Arguably, the most powerful man in the world spoke last week, and within minutes billions
of wealth were created. Of course I am speaking about Federal Reserve Chairman Alan
Greenspan, who, along with his fellow members of the Federal Reserve Open Market
Committee, announced a quarter of a percentage point increase in the Federal Funds Rate to
5 percent.
Normally interest rate increases are not good news for investors. Rising interest rates
tend to slow the economy by increasing the cost of credit. This impacts businesses by
increasing costs and reducing profits, earnings, and stock prices.
Consumers feel the pinch as credit card interest rates increase, as do mortgage loan
rates. This tightening of credit tends to slow consumer spending, which further
exacerbates the constraints on business earnings and stock prices.
But this tightening of credit was viewed around the world as good news. Within minutes
after the announcement from the Fed, the Dow shot up nearly 200 points. European stocks
surged two percent the next day on the news. Tokyo’s benchmark Nikkei average closed
up 2 percent, its highest close of the year. And, our bond market reacted by increasing
the price of the 30-year U.S. Treasury, which lowered its effective interest rate to
slightly below 6 percent before the end of the trading day.
These seemingly contradictory reactions to an interest rate hike came more not because of
what was said, but rather what Greenspan and friends implied. They indicated that a slight
tap on the economic brake was all that was needed at this time to keep our economy in
check. Their collective bias was toward maintaining a neutral, near-term outlook for
future rate hikes.
To better understand the task of the Fed, imagine driving a heavily loaded truck down a
very steep mountain pass. At key points along the road you pull your truck over to check
its brakes and the load. That is what the FMOC does when it holds its periodic meetings to
assess the state of the economy and the prospects for inflation.
Once you start down the mountain, you have to keep your truck under control by tapping the
brakes. If you let it go too fast, its momentum will overtake the capability of the brakes
to hold it and you will have no choice but to bring it to a screeching halt on a runaway
truck ramp.
Greenspan and the Fed understand the need to tap the brakes and control the
momentum of the economy. The tough part of their job is to determine when and how much
pressure to apply. It generally takes 12 to 18 months for Fed policy to show real effects
on the economy. Even though they raised interest rates now, economic growth could continue
to accelerate, bringing with it further threats of inflation and the need for further rate
hikes.
"When we can be pre-emptive we should be," Greenspan
told a Congressional Committee, "because modest pre-emptive actions can obviate
the need for more drastic actions at a later date that could destabilize the
economy."
With Mr. Greenspan driving our "truck," investors and economists
believe the Fed will be able to control our juggernaut economy and bring the whole load
down off the mountain to a "soft landing." If he can do this, inflation can be
held in check and the economy can be kept from toppling into a recession.
