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US Monetary Policy: Gloom or Bloom?

As Wall Street analysts listened to Alan Greenspan's surprisingly downbeat testimony on the US economy last week, a telling moment came when a lawmaker asked him to pinpoint the timing of recovery.

The Federal Reserve chief hesitated, then said reluctantly: "If I have to make a forecast ... towards the end of this year we will see things improving, clearly so next year."

Fed watchers said the chairman's reticence underscored a difference of opinion within the marbled walls of the central bank: Greenspan is more worried than many of his colleagues that economic events could worsen before they get better.

"The crucial question is, how much economic stimulus do we have in the pipeline?" said economist Jan Hatzius of Goldman Sachs in New York.

Greenspan, who spoke to the House Financial Services Committee last week in the first leg of his semi-annual monetary testimony, will appear again on Capitol Hill today before the Senate Banking Committee.

He is expected to repeat his formal testimony but senators will have a chance to grill him further about the economy.

The stimulus to the US economy is expected to result from the six interest rate cuts the Fed made during the first half of this year. The recently enacted tax cut that will provide rebates of up to US$600 for American households is expected to provide added juice to the recovery.

Prior to Greenspan's testimony last Wednesday, Wall Street was looking for him to offer a fairly optimistic scenario for the economy based on this monetary and fiscal stimulus and to highlight recent signs of improvement in the economic data.

One reason they thought the testimony would be upbeat is that other Fed officials, such as Anthony Santomero, president of the Federal Reserve Bank of Philadelphia, have expressed a fair amount of confidence in a near-term economic recovery.

"Gradual acceleration to a more acceptable pace of economic growth seems likely," Santomero said in a June 8 speech. "Therefore, it is not clear how much more of an adjustment in monetary policy is necessary."

Santomero went even further to warn of the risk that monetary policy by the end of the year could end up being overly stimulative if the Fed continues easing rates.

"We do not know for sure what the economic conditions will be by then, but I think there is some risk that the arrival of such stimulus could be ill-timed," he said.

Fed Governor Laurence Meyer, an influential member of the Fed's policy board, has also spoken of the need to "calibrate" rate cuts so as to avoid giving the economy too much gas and stirring up inflationary pressures.

In contrast, Greenspan in his latest testimony stoked expectations of further cuts, saying with uncharacteristic bluntness that the "subpar economic performance" is not over and the economy "may require further policy response."

His remarks led analysts to conclude that at the Fed's next meeting on August 21, a seventh rate cut is virtually a done deal. In a poll, all 25 primary dealers of US government securities forecast a quarter-point rate cut on August 21. Overnight interest rates now stand at 3.75 per cent.

Goldman's Hatzius and other analysts said the crux of the debate at the Fed involves the long-held theory that there is a "lag," or time delay, of six to 12 months, before the full force of a change in rates works its way through the economy.

As his colleagues do, Greenspan buys into the lag theory and has even suggested that the lags lately may have grown a bit shorter - possibly only six to nine months - because of the speed with which markets respond to new developments.

But observers say he may be more sceptical than some other Fed officials that monetary policy will work the same magic it usually does in pumping up growth during the current slowdown.

"Some Fed officials are banking on the lagged effects of the interest-rate cuts to show up on the economy later this year," Hatzius said. "Others caution that lower rates don't work in a vacuum if financial conditions elsewhere in the economy do not accommodate them."

Those restrictive conditions include a strong US dollar, which is curbing the appetite abroad for American-made goods, and the struggling stock market, which could restrain spending by consumers and businesses domestically.

Another factor restraining the effectiveness of monetary policy is the fact that longer-term interest rates have not fallen in tandem with short rates.

"Greenspan is very uncertain of the timing of the lag," said David Jones of the economic consultancy DMJ Associates in Denver.

He said an additional concern Greenspan may have is that even as the economy gets a lift from lower interest rates and the recently enacted tax cuts, a boom-bust cycle in the high-technology sector may take a while to play out. That could exert a drag on growth.

Makers of computers and communications equipment saw demand for their goods rocket in the late 1990s through mid-2000, prompting them to beef up capacity at their factories to churn out goods. But now much of that new capacity sits idle after demand has collapsed and many workers have been laid off.

(China Daily 07/24/2001)

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