Fed Raises Rates Again

Alan Greenspan and the governors of the Federal Reserve bumped interest rates up another quarter of a percent. The fed funds rate is now at 1.5%. On one level, it is possible to debate the wisdom of this move but on quite another, this was a dreadful mistake that in the end may force the Fed to move interest rates higher than necessary. The former debate is economic in nature, but the mistake is in the realm of market psychology.

A pro-Greenspan economist will look at this rate increase and say that the American recovery is continuing, although there are indications that it is slowing. However, prices are showing signs of increasing, and inflation remains the great Bogeyman of the capital markets. By raising rates now, the Fed is trying to keep that inflation in check. An anti-Greenspan view, and there aren't many who hold to this long-term, says that the job market is performing badly, consumer spending is showing signs of vanishing, and oil prices are responsible for the general rise in costs throughout the economy. The rate hike could have waited in case the oil effect undoes the recovery. This latter view makes more sense.

However, the Fed made a big mistake in raising rates when it did from a market psychology perspective. The market fully expected the increase, and it was priced into the yield curve and stock valuations. There was a sliver of doubt based on the anemic jobs report for July. That doubt is key to any central bank's ability to deal with markets that have a tendency to run away with themselves. When central bank policy becomes a one-way bet, in this case rate hikes, the market is not impressed unless expectations are exceeded. And nothing exceeds like excess -- rates will have to rise too much to get the attention of the traders and speculators. Foreign currency markets are notorious for overshooting thanks to central bank predictability.

Far better for the Fed to have kept its powder dry. If Mr. Greenspan is right, that the economy merely entered a soft patch, the Federal Open Market Committee, which sets these rates, could have given him the power to hike two week's hence, or delayed until the next meeting. In either case, the Wall Street assumptions would have been called into question. Doubt prevents positions building up that dampen the effectiveness of Fed policy. The ideal is for a third of Wall Street to believe a rate hike is coming, a third believe that rates will hold steady and the latter third believe that the rates are actually going down. That's when the Fed gets bang for the buck.

Mr. Greenspan remains a well-respected economist and central banker, and the world has done well under his tenure at the Fed. However, even the best make mistakes, and in this case, Mr. Greenspan had a chance to wrong-foot the market and hold the line on rates. He chose instead to do what the market expected. That may be a decision that the country may come to regret.


© Copyright 2004 by The Kensington Review, J. Myhre, Editor. No part of this publication may be reproduced without written consent.


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