Greenspan’s Optimism
The Maestro likes what he sees -- but is he right on inflation?


David Malpass

In congressional testimony Wednesday, Federal Reserve chairman Alan Greenspan left the impression that the economy is strong and strengthening and that interest rates — while they will rise at some point — will remain generally accommodative. More, while recognizing the sustainability of the economic expansion, he doesn’t see it as inflationary.

I share Greenspan’s optimism on the economy, but I think it would be more pro-growth and less risky on the inflation front to raise interest rates a little bit now and, separately, to recognize the likely impact of the weaker dollar on prices.

In his testimony, it was hard to detect any change in the Fed’s model of inflation. Greenspan said in a key paragraph of his text that “More broadly … although the recent data suggest that the worrisome trend of disinflation presumably has come to an end, still-significant productivity growth and a sizable margin of underutilized resources, to date, have checked any sustained acceleration of the general price level and should continue to do so for a time. Moreover, the initial effect of a slowing of productivity growth is more likely to be an easing of profit margins than an acceleration of prices.” (Emphasis added.)

That’s not quite right. Inflation has been muted in the economy so far not because of productivity growth and idle capacity, but because inflation is a backward-looking measure which lags the change in the value of the dollar. But again, the Maestro is right to be optimistic. Here’s a quick breakdown on where our central bank stands on the major economic topics:

On Growth: Greenspan called the U.S. expansion “vigorous.” He saw good prospects for “sustaining solid economic growth in the period ahead,” continued impetus to domestic spending, and an improvement in business confidence. In his congressional Q&A, he noted a “significant improvement in the economy in recent months.”

On Inflation. Greenspan did not see an “environment in which broad-based inflation pressures appear to be building.” In a Q&A on productivity growth, he said that price pressures are nowhere near what they were in the past, allowing a much more measured pace of interest-rate hikes today.

On Productivity vs. Inflation. Greenspan emphasized the ability of productivity growth to counteract inflation pressures. In the Q&A, he said that, given the underlying structure of costs, prices, and profitability, the emergence of inflation at a reasonably rapid pace is nowhere on the horizon.

And finally . . .

On Interest Rates. Greenspan saw only that “the federal funds rate must rise at some point to prevent pressures on price inflation from eventually emerging.”

The country is headed into a durable expansion which will be marked by mild inflation and higher interest rates. But on interest rates — higher and sooner would be a welcome development.

– David Malpass is the chief global economist for Bear Stearns.