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[TTHQ Staff]

BEING STREET SMART
___________________

Sy Harding

ALAN GREENSPAN’S ROAD TO RETIREMENT! September 9, 2005.

Federal Reserve chairman Alan Greenspan, 79 years old, will end his 19-year career with the Fed on January 31. I’m guessing that about now he might be wishing his retirement had come a bit sooner.

Greenspan has served through five presidential terms, which included both Republican and Democratic Administrations. Probably no one, except the various presidents themselves, have been subject to more praise - or more criticism. He has been called a financial maestro who repeatedly navigated the economy past dangerous shoals, and guided financial policy that created one of the longest economic booms in history, while also keeping inflation under control. And he has been called a fool whose easy-money policies created the overheated stock market bubble of 1999, the current record consumer debt, and bubble in the real estate sector.

There is no middle ground when it comes to opinions about Greenspan. Historians will debate his legacy for decades.

Previous changes of regime at the Fed have often created uncertainty and volatility in the markets. But, until a couple of weeks ago, it was thought it would be an easy ride to Greenspan’s retirement, and an easy transition period for his replacement.

After all, the economy has been in a period of relative calm, neither too hot nor too cool, and the stock market in a flat trading range for 20 months. The Fed has felt comfortable enough with the strength of the economy that it was sure it could prevent inflation from becoming a problem by simply raising interest rates ‘at a measured pace’. Analysts expected the Fed would be finished with the rate hikes by the end of the year, and the next Fed chairman could then sit back and observe for awhile before any further decisions would be required.

Part of the Fed’s confidence that the fight against inflation would be temporary and easy came from Greenspan’s observations that, in spite of higher costs in other areas, “labor costs continued to be contained”.

That is an important observation, since the nightmare of all economists; ‘spiraling inflation’, cannot develop without rising wages playing their part. Spiraling inflation is the situation where the prices of commodities rise, making it more difficult for workers to cope with their cost of living, resulting in demands for higher wages. The higher wages then create still higher costs for businesses, so they raise their prices again. And soon the process feeds on itself and spirals out of control.

Once an inflationary spiral begins, history shows there is no easy fix. Interest rate hikes often work to cool off an economy and prevent inflation, but not well at all once inflation is out of the bottle. Some of us remember the 1970s, when interest rates were hiked to the point where mortgage rates and business loans were on the order of 15%, which had the economy stagnant, while inflation soared. Stagflation. President Nixon tried to fix it by instituting price controls, with disastrous results. Jimmy Carter took office and was so pessimistic about it he told the country that the decades of U.S. prosperity were over and the nation needed to get used to a lower standard of living.

So the Fed’s fear of inflation getting out of control is understandable. And that may create a few headaches for the Fed and Greenspan on his road to retirement.

The Fed has been calmly raising interest rates ‘at a measured pace’ since June of last year, in an effort to slow the economy and prevent the inflation in basic materials and energy from spreading into the area of wages. It doesn’t want to go too far and land the economy in a recession. Yet it fears inflation more, since it feels it knows how to fix an economy that has slowed too much. (As it has often demonstrated, reversing course by lowering interest rates and providing easy money always gets the economy moving again).

Even prior to the Katrina disaster, inflation in basic material and energy costs had spiked higher. But the economy, although its growth was slowing, remained strong enough for the Fed to be confident that it could continue to raise interest rates to slow it without causing too much damage, and thus prevent inflation from spreading further, particularly into wages.

However, the Labor Department reported this week that ‘unit labor costs’, a key indicator of wage inflation, increased at a 2.5% rate in the 2nd quarter. And that was before Katrina.

Now, in the wake of the Katrina disaster, economists have been lining up to downgrade their economic forecasts and raise their expectations for inflationary pressures.

A Wall Street Journal poll of economists conducted last week and released on Thursday, shows a majority expect Katrina to “slow economic growth, and boost inflationary pressures, for the second half of this year”. And in spite of the prospects for a slowing economy, that the Fed will have to continue to raise interest rates due to the increase in inflationary pressures created by Katrina.

A slowing economy and rising inflation. Stagflation?

They had no forecast as to how the markets might react if that scenario begins to play out.

Meanwhile, analysts are crediting the market’s continuing resilience to belief that the Fed will stop raising interest rates in response to the economic impact of Katrina.



Sy Harding is president of Asset Management Research Corp., DeLand, FL, publisher of The Street Smart Report Online at www.streetsmartreport.com and author of 1999’s Riding The Bear – How To Prosper In the Coming Bear Market.