All is well, and perhaps not so well. There is recovery, but also a shadow.
The economy is receiving "considerable upward impetus from a marked swing in inventory investment," but "the degree of the strengthening in final demand -- is still uncertain," the Federal Reserve's Open Market Committee said in a terse statement Tuesday afternoon.
So we stay the same, no change of course. The economy will sail on, its engine sustained by the lowest interest rates in 40 years, and we will wait and see if all is indeed well, or if there are rocks somewhere on which the recovery might founder.
The economic slowdown that began in 2000 continues to leave room for uncertainty, even after the annualized gross domestic product growth rate of 5.8 percent in the first quarter of this year. The slowdown provoked a vigorous policy reaction from veteran Federal Reserve chairman, Alan Greenspan, and from President George W. Bush's administration, which has slashed taxes and raised spending
How great is the shadow over the economy?
Let us turn for some thoughts to another shadow, the other Allan: Professor Allan Metzler of Carnegie-Mellon University in Pennsylvania, who was one of the two founders of the Shadow Open Market Committee of economists in 1973.
The shadow group is an interesting creation. Of course, every word of Alan Greenspan and the real committee is mulled over, criticized and reviewed by a host of academics, business economists and journalists.
To my knowledge, only the shadow committee is made up of a panel of distinguished economists who meet, in the manner of the real committee, to discuss monetary policy, and who issue a statement and policy recommendation after their meeting, as the real committee does. But the shadow committee's comments are much longer.
The shadow committee's last meeting took place just three weeks ago on April 15. The tone of its statement differs considerably from that of the Fed's Open Market Committee, and the policy recommendation is different, too.
Committee members said that at the October meeting they argued, unlike others, that the shock from the events of Sept. 11 "were likely to be short-lived and that the economy was likely to recover relatively quickly. These predictions have been borne out."
While rejoicing in the swift recovery it perceives, the shadow group is critical of the policies behind recovery. It asserts that in 2001 "monetary policy was excessively stimulatory by any metric." It points out that the federal funds rate, the key short-term interest rate that the Fed has guided to just 1.75 percent, is "negative in real terms" -- that is to say, lower than the inflation rate. It writes that the monetary base rose by over 8 percent in 2001 and M2, a broad measure of money growth, by 10 percent. The danger, the shadow group argues, is that inflation will rise.
"The general thrust of monetary policy points toward inflation rates rising to 4 percent," the shadow group writes, "Monetary policy is too accommodative and must be reversed."
Who is right? On Wall Street there would have been immense dismay if Greenspan had listed to the advice of the shadow group and raised the fed funds rate this afternoon. The stock market, which, correctly, did not expect such a move, would have fallen heavily. But the fact that Wall Street would not have liked a rise in interest rates now would not necessarily make the decision wrong.
The shadow group is right to suggest that monetary policy has been loose and is loose. Its fears that this may cause inflation in the future cannot be discounted. Yet its confidence in the fundamentals of the U.S. economy and the strength of economic recovery seem misplaced. The Fed's statement warning that the strength of economic recovery is still "uncertain," seems warranted. Even with a very loose, perhaps excessively loose, monetary policy, the U.S. economy looks far from robust.
The recession to which the U.S. economy began to slide in 2000 is an unusual one. In the first place, it is not a recession at all, according to the usual definition, in that the economy declined for one quarter --- the third quarter of 2001 --- and not two. The shadow committee concludes that it "likely will go down as the mildest in the post-war era." But this judgment may be premature. If the economy cannot rebound when short-term interest rates are negative, perhaps somewhat is more badly wrong than the shadow group suggests.
The problem is that the U.S. economy was driven forward in the second half of the 1990s by an unsustainable asset price bubble. That bubble has not yet deflated. Valuations on U.S. stocks remain stretched. And the very low interest rates introduced last year helped to ensure that a bubble continued to build in house prices. U.S. consumers continue to spend more and sustain the economy because of the wealth effect from housing.
A bubble propelled the U.S. boom and drives its decline. That is why monetary policy, though a palliative, cannot yet guarantee recovery. Greenspan is cautious, and is perhaps right to be. He has in mind the 1930s and Japan's long depression following the bursting of its asset bubble in the 1980s.
The United States is in territory that monetary policy rarely treads. Normally it is inflation that causes policy tightening and recession. This time the inflation was in asset prices. Perhaps it was while that asset price inflation was building that monetary policy needed to be more tight.
Had monetary policy not been so accommodative in 2001, there can be little doubt that the U.S. economy would now be in recession, stock prices would be much lower, and so would house prices. The wealth effect that has helped to support the U.S. economy would have been replaced, in the case of stocks, by a negative wealth effect.
Greenspan's loose monetary policy has helped to avert that threat. Most Americans, economists and otherwise, will applaud him for it.
Yet it cannot be certain that Greenspan's response has been right. Perhaps it would be better to deflate that bubble more quickly. Then other signs of imbalance in the U.S. economy, the very low savings rate, the very high trade and current account deficits, would correct, and the United States might indeed be ready to begin a recovery. But, after so long a boom and so big a bubble, it cannot be clear to anyone, to either the real group or the shadow group, what effect deflating the bubble quickly would have.
Still the shadow of a deep and persistent decline in the U.S. economy stalks Greenspan. He is aware of grave dangers and has played his cards boldly against them. Only time will tell if he was right.
Comments to [email protected]
