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Closing the book on the Greenspan era

He kept the economy on an even keel for decades; now Alan Greenspan is turning over a shaky nation to his successor as he steps down today.
Tuesday, January 31, 2006 | 12:00 a.m. CST; updated 12:23 p.m. CDT, Sunday, July 20, 2008

WASHINGTON — The legendary Alan Greenspan is stepping down today as chairman of the Federal Reserve at a particularly dicey time for the nation’s apparently robust economy.

As a result, when successor Ben S. Bernanke takes over the job Wednesday, he will face a difficult choice walking into his new job: whether the Fed should continue, or suspend, its recent campaign of raising interest rates.

Unemployment is below 5 percent. Inflation is moderate. Workers are becoming more productive.

But potential trouble is bubbling beneath this calm surface. After remarkably consistent growth for three years, the economy slowed at the end of 2005. The housing market, which has fueled growth, is showing signs of cooling. Oil prices are high. Consumers are spending more than they earn, a trend that can’t last forever.

The United States is deeply dependent on foreign lending — particularly from China — to finance its outsized trade and budget deficits.

The Fed, whose job is to keep prices stable without suppressing economic growth, has already done the easy work.

For the past 20 months, Green­span’s Fed has tapped on the monetary brakes at every opportunity, gradually raising short-term interest rates. In June 2004, the rate controlled by the Fed stood at a recession-fighting low of 1 percent. In 13 equal steps, the Fed has raised it to 4.25 percent to fight inflation and prevent the economy from overheating.

The Fed has signaled the public to expect another rate hike at today’s meeting, which will be Greenspan’s last. That will nudge its benchmark rate to 4.5 percent, the low end of the range at which analysts have estimated the Fed would stop.

From then on, the Fed will have to decide when enough is enough.

If it continues to raise interest rates, consumer debt repayments could become more difficult and the housing market could feel the pinch. But if the Fed ends the rate-hike campaign, it will increase the risk of inflation, which is probably more of an immediate threat now than it was a year and a half ago.

“Broadly speaking, the economy is in a pretty good place,” said Mark Zandi, chief economist of Moody’s Economy.com in West Chester, Pa. “But it’s no longer obvious what the next step should be. Now it gets a lot more complicated.”

Whatever the Bernanke Fed does, the new chairman will not do it single-handedly. Interest-rate decisions are made by the Federal Open Market Committee, which consists of Bernanke and the six other Federal Reserve Board governors, plus five of the 12 regional Fed bank presidents.

Greenspan, by virtue of his stature as well as his skills of persuasion, generally carried the other committee members with him. During the 13 consecutive meetings at which the committee raised rates by one-quarter point since June 2004, only one dissenting vote was cast — by a member who, immediately after Hurricane Katrina, felt the Fed did not have enough information about the hurricane’s economic impact to vote intelligently.

But now, “the guy who’s kept them on a leash is going to disappear,” said Lawrence Lindsay, an economist who was a Fed board member from 1991 to 1997 and who voted against Greenspan’s majority four times in 43 opportunities. He predicted stormier times ahead at the closed Open Market Committee meetings.

Bernanke’s first meeting will be eight weeks into his tenure, time enough for him to begin to build consensus, said Kevin A. Hassett, director of economic studies at the American Enterprise Institute, a conservative Washington research organization.

“There is going to be a lot of uncertainty in the first couple of months, but Bernanke will quickly establish himself,” Hassett said.

Bernanke’s first rate-hike decision will be influenced by Greenspan’s last official pronouncement — the statement that the Open Market Committee issues today to explain its expected move to raise the federal funds rate by another quarter point, to 4.5 percent. The federal funds rate is the interest on overnight loans between banks.

David Kelly, managing director of Putnam Investments in Boston, said Bernanke would find it politically difficult, without help from Greenspan, to preside over the end of 14 consecutive rate increases choreographed by the maestro of monetary policy. Greenspan could, and Kelly said he should — construct a statement at Tuesday’s meeting explaining the rate increase in such a way that would leave his successor maximum flexibility to act as he saw fit.

“This will be potentially the most important Federal Reserve Board meeting of the decade,” Kelly said. “On Alan Greenspan’s last day on the job, he’s going to have a chance to leave the car parked in neutral.”

Looking beyond Bernanke’s first Fed meeting, Zandi warned of the dangers that set in when an economic expansion gets long in the tooth, as this one has. In those situations, he said, policymakers can no longer encourage economic growth with little risk of inflation.

“Now we’re at the point in the business cycle when the economy could slip a gear,” Zandi said. “I think he (Bernanke) should plan on it.”

Fed chairmen have sometimes undergone trial by fire early in their tenure. In the case of Greenspan, who became Fed chairman in 1987 at about the same stage of the business cycle as now, an October stock market crash sent the Dow Jones industrial average tumbling nearly 23 percent in a single day. Thanks in large measure to the Fed loosening its grip on the money supply, the economy weathered that storm without a recession.

Zandi said there was no shortage of flash points now. To him, the potential for a cooling of the red-hot housing market is the “major fault line in the economy.” Home equity loans and no-down-payment mortgages have provided millions of Americans with spending money — but less equity in their homes. A turndown in home values could leave them owing more on their homes than their homes are worth.

Existing home sales fell 5.7 percent in December.Energy prices represent another threat, and one that could be aggravated by higher interest rates. Philip Verleger, a senior fellow with the Institute for International Economics, can imagine the world oil price, now in the $60-to-$70-per-barrel range, surpassing $100 by year’s end.

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