To all - O.T. -- Here is today's WSJ article about what the Fed has been "up to" in the past few months :
November 17, 1998
How the Fed Fumbled and Then
Recovered in Making Policy Shift
By DAVID WESSEL
Staff Reporter of THE WALL STREET JOURNAL
WASHINGTON -- Shortly after the Federal Reserve announced early in the
afternoon on Sept. 29 that it was cutting interest rates, top Fed officials
realized they had made a mistake.
They had hoped their first rate cut in nearly three
years would reassure financial markets that the
world's most powerful central bank was
prepared to do what was needed to avoid a
global economic meltdown.
But Fed Chairman Alan Greenspan, known for often-obscure pronouncements,
had sounded a clear alert that a rate cut was imminent, and the markets
shrugged when the Fed trimmed just a quarter percentage point off its key
short-term interest rate.
Edward Boehne, president of the Philadelphia Federal
Reserve Bank, says he knew a few days later that the
Fed had goofed. When he checked into a hotel in a
small town in Pennsylvania, the clerk looked at his
title and said, "You didn't do enough."
"You don't usually get that from a hotel clerk," Mr.
Boehne says.
Inside the Fed, the next two weeks were filled with
introspection and second-guessing of Mr.
Greenspan's go-slow proclivities.
The handful of Fed policy makers who had argued
for a more dramatic half-percentage-point rate cut
felt vindicated. Officials at the Federal Reserve Bank of New York worried that
the rate cut had done little to reverse a stampede away from risky, and even
not-so-risky, bonds.
Something More
Quietly, but forcefully, New York Fed President William McDonough, 64,
who sees himself as a potential successor to the 72-year-old Mr. Greenspan,
and Alice Rivlin, the former White House budget director who is vice chairman
of the Fed, pushed for something more.
That "something more" turned out to be a surprise quarter-percentage-point
cut in rates on Oct. 15, a moment that Mr. Greenspan chose because he
sensed that financial markets were ready to respond favorably.
The Fed knew the move would grab attention: It was first time since 1994 that
the central bank had changed interest rates between scheduled
policy-committee meetings. But would it provide a jolt of confidence to the
markets? Or would it be seen as evidence that the Fed's take on the financial
crisis was bleaker than everyone else's?
To the Fed's relief, it turned out to be the former. Markets rallied instantly, and
have hardly looked back.
Indeed, as Fed officials prepare to sit down Tuesday around their two-ton
mahogany-and-granite conference table to ponder another rate cut, prospects
for the U.S. economy look rosier than they did a month ago -- so much better
that some Wall Street analysts who were confidently predicting the Fed would
reduce rates again now aren't so sure.
Promising Signals
The economy seems to be growing at a better-than-expected pace of nearly
3% in the second half of 1998. The stock market is ebullient, causing a few at
the Fed to begin worrying again about "irrational exuberance," and prompting
some to raise forecasts for consumer spending next year. Global markets are
calmer.
Nonetheless, the Fed's internal forecasts indicate the economy will slow
substantially in the first half of 1999, putting the nearly eight-year-long U.S.
expansion at risk. The bond market is still showing signs of stress and lack of
liquidity. And Fed officials know that if they are to give any boost to next
year's economy, they must move soon. But whether or not a rate cut comes
Tuesday, the widespread expectation is for further cuts in the months ahead.
For an institution that rarely changes direction quickly, this is a remarkably
rapid about-face. After all, the Fed came very close to raising interest rates this
past spring because it feared the unexpected vitality of the U.S. economy
would lead to inflation.
The policy change reflects the deterioration of the global outlook following
Russia's default on its debts in August. But the Fed hasn't always reacted
rapidly to changes in the financial environment. Indeed, at times, it has prided
itself on not being swayed by Wall Street phobias of the moment.
For several reasons, this time was different:
The current crop of Fed policy makers is more pragmatic than in the
past. Those who adhere to a particular school of thought -- tracking the
money supply or comparing today's jobless rate to the rate at which
inflation has taken off in the past -- have been trumped by the fact that
inflation hasn't taken off as they anticipated. Inflation has been falling
even though unemployment is at a quarter-century low. To predictions
from Fed colleagues that inflation is around the corner, Mr. Greenspan
has replied simply: Show me evidence. There hasn't been much.
Influential Fed officials, including Mr. Greenspan, saw this as a time
when prudent policy meant looking beyond conventional gauges. It
meant asking questions like: With Japan in political paralysis and Europe
preoccupied with monetary union, what can the U.S. central bank do to
avert a global financial catastrophe? The Fed rarely faces such
questions, but when it does, the consequences of error are huge:
witness the Great Depression.
Mr. Greenspan, who dominates the institution he has run since 1987,
saw a threat to what he calls the best economy in 50 years. Credibility
is hard to measure, but Mr. Greenspan has lots of it. When he resisted
pressure to raise rates, the markets didn't assault him as soft on
inflation, and his uneasy colleagues didn't revolt. When he decided it
was time to cut rates, the rest of the Fed followed.
Although the Fed chief cultivates consensus, there is no doubt who calls the
shots. At meetings of the Fed's policy-setting Federal Open Market Committee,
Mr. Greenspan listens as each official gives his or her views on the economy.
But when it is time to decide what to do about interest rates, Mr. Greenspan
speaks first. Anyone advocating a different policy has to make a deliberate
decision to differ with him.
A majority on the FOMC had been eager to raise rates early in the fall of 1997,
before the virulence of the Asian flu was evident. That September, Mr.
Greenspan held them off, arguing that he hadn't prepared the markets. When
the committee reconvened in October and November, intensifying economic
woes in Asia made raising rates nearly impossible.
When the FOMC met at the end of March, the Asian financial crisis appeared
to be in remission. The long-predicted slowdown in the U.S. economy had
failed to arrive. The ghost of inflation was lurking, even if there were few
signs that wages or prices were going up more rapidly.
"There was a sense that maybe the Asian drag wasn't going to be as great as
anticipated," Alfred Broaddus, president of the Richmond, Va., Federal Reserve
Bank, recalled in an interview during the summer.
Signing On
Again, Mr. Greenspan, who doubted that the wage increases feared by some
Fed officials would actually materialize, talked his colleagues out of raising
rates. But he joined the consensus that a rate increase was "a likely prospect in
the not too distant future," according to a published summary of the session.
The question wasn't if, but when. With unemployment at a low 4.6% and the
pace of money-supply growth quickening, there was no thought given to
cutting rates.
By July, a rate increase no longer seemed a certainty-at least to Mr.
Greenspan. Although the FOMC was still formally leaning in favor of higher
rates in the written statement it crafts at the end of each meeting, the chairman
signaled in congressional testimony in late July that he wasn't. By the Fed's
August meeting, which came just a day after Russia's default, it was clear that
weakening exports and mounting inventories were squeezing American
manufacturers. Few Fed officials still were thinking about higher rates, but
most weren't ready to lower them.
Each year at the end of August, Mr. Greenspan and other top Fed officials
attend the Federal Reserve Bank of Kansas City's conference at Jackson Hole,
Wyo., in the majestic Tetons. This year's topic was inequality, but the only
subject of coffee-break, hiking-trail and golf-course conversation was what to
do about the spreading global financial crisis. Private economists, eager to be
quoted, sought out reporters to argue for cutting rates. Fed officials, just as
eager not to be quoted, pooh-poohed those arguments.
But the important conversations were taking place in the quiet huddles in and
around the Jackson Lake Lodge among the five Fed governors, seven Fed
bank presidents and top Fed and foreign central-bank staffers who were there.
The market reaction to Russia's default was severe and unexpected. The daily
reports that the New York Fed prepared for officials showed a worrisome,
widening gap between the yield on corporate bonds and government bonds, a
rare occurrence except when the economy is in recession. In the market for
supersafe U.S. Treasury bonds, there was an unusually strong preference for
the most easily traded issues, which the Fed read as a sign of unhealthy
anxiety.
Speaking Up
It was, the Fed officials agreed, time for them to say something to the world.
Mr. Greenspan stuck to his plan to spend a week at a tennis camp, though he
got so many phone calls about the plunging stock market that he jokes that he
kept a tennis racket in one hand and a cellular phone in the other. But a speech
planned for the University of California at Berkeley's business school on
Friday, Sept. 4, offered a convenient opportunity.
Clearing key passages in advance with each member of the FOMC, Mr.
Greenspan declared that the U.S. couldn't hope to remain an "oasis of
prosperity." As flatly as he ever says anything, he said the Fed no longer was
leaning toward raising rates.
A week later, a statement from the world's leading central bankers and finance
ministers led to speculation that the central banks would cut rates in concert.
But Mr. Greenspan and his peers don't like anyone thinking they subordinate
national priorities to global ones -- even if they sometimes do. Mr. Greenspan's
German counterpart, Hans Tietmeyer, quickly quashed the notion that he was
coordinating anything with anyone. Mr. Greenspan did the same, telling
Congress on Sept. 16, "At the moment, there is no endeavor to coordinate
interest-rate cuts." He said other things, too, but that was all the markets
heard.
In the days that followed, bond-market investors grew even more skittish,
making it difficult for many firms to borrow. Caught off-guard, Long-Term
Capital Management LP, the huge hedge fund, came crawling to the New York
Fed, saying it needed capital and was having trouble raising it. If LTCM's
holdings were dumped on the bond market all at once, New York Fed
President McDonough told Mr. Greenspan, the odds of calamity were
uncomfortably high. On Sept. 20, New York Fed officials got a look at
Long-Term Capital's books. They were shocked.
While Mr. McDonough and his staff tried to organize a Wall Street rescue of
Long-Term Capital, Mr. Greenspan focused on how perplexed the markets
were about the Fed's inclinations.
To keep other Fed officials happy, Mr. Greenspan makes major policy changes
only at FOMC meetings -- partly so the Fed doesn't look like the one-man
show it often is. But the FOMC wasn't set to meet until Sept. 29. He didn't
want to wait. He accepted a standing invitation to testify before the Senate
Budget Committee. On Sept. 21, even though some Fed officials were
unavailable because it was the Jewish New Year, he convened a conference
call to be sure his colleagues were also ready to cut rates.
They were. On Capitol Hill, Mr. Greenspan essentially announced the Fed was
about to act. "We know where we have to go," he said. The stock market
cheered, even though it would be six days until the Fed actually lowered to 5
1/4 % its target for the federal-funds rate, the interest rate at which banks lend
to one another.
'Irrelevant' Amount
The argument for initially cutting rates by only a quarter point prevailed
because most Fed officials figured that simply changing direction would make
a big enough splash. "I thought the amount was irrelevant," says Mr. Boehne,
the Philadelphia Fed president. "The problem with 50 basis points"-jargon for a
half percentage point-"was that people could have inferred that we knew more
bad things than we did." Mr. Greenspan made the same argument internally.
But after the Fed's Sept. 29 announcement, the stock market sagged, and the
worrisome spreads in the bond market widened.
A week later, Mr. Greenspan delivered a rambling, off-the-cuff early morning
speech to the National Association for Business Economics. He had two goals.
The first was to dispel the sense of doom and gloom that had descended.
Officials from emerging-market economies who had come to Washington for
the annual meetings of the International Monetary Fund and the World Bank
had talked as if the era of capitalism were over. The press was filled with what
he considered overblown talk of a wrenching credit crunch.
The second goal, somewhat at odds with the first, was to lay the foundation
for another rate cut by detailing the evidence that uncertainty and fear were
causing investors to, as he put it, "disengage."
But when to cut? Fed officials couldn't afford another tactical error or
muddled message. They didn't want anyone to think they were responding to a
particular economic indicator, to a down day in the stock market or to rumors
that a big bank was about to collapse.
Time for Action
By Thursday, Oct. 15, Mr. Greenspan figured the spreads in the bond market
he had been tracking had grown so wide that they were bound to begin to
narrow soon. It was time. He convened a telephone conference call of the
FOMC.
Participants say the hour-long conversation was unusual. Breaking from past
practice, Mr. Greenspan let each Fed governor and bank president speak
before stating his druthers, an effort to bolster the sense that he was seeking a
consensus. When he disclosed his plans, no one objected strenuously -- and he
didn't ask for a vote.
The move was a success (except for an embarrassing typo in the 3:14 p.m.
news release, in which the Fed misstated the details of the rate cut). Stocks
and bonds leapt. One measure Mr. Greenspan has been tracking closely -- the
difference between yields on more-easily traded and less-easily traded
Treasurys -- improved.
On their TV sets and computer screens, Fed officials watched the instant
analysis with a bit of trepidation. But the reaction was almost universally
favorable, and the intended message was received: The Fed was prepared to
do what was necessary. "Yes!" one Fed governor said late that afternoon after
listening to a Wall Street pundit on CNBC, the business cable channel. "They
got it right."
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