The Clinton-Greenspan Alliance

May 18, 1994

The Federal Reserve Board's decisive increase in short-term interest rates yesterday should put a quick end to the uncertainty that has roiled world financial markets in recent months. Uncertainty is the bugaboo of investors everywhere and leads to irrational responses. While the Fed's theory that pre-emptive action would head off inflation is persuasive, its super-cautious incremental approach to its task proved counter-productive. Each quarter-point rise in the federal funds rate merely boosted expectations for a further increase.

Now that shoe-dropping period is over. By pushing up both the discount rate and the fed funds rate by half a percentage point, the nation's central bankers signaled a virtual end to their search for "neutral" ground to sustain a long, steady economic expansion.

Once again, President Clinton reacted to the Fed's moves with realism. Even before yesterday's rate increase, the president declared: "If it happens, it be will because we have growth. . . There is clearly some room" for higher short-term rates. These were the words of a Democrat yearning for prosperity in election year 1996. He and Treasury Secretary Lloyd Bentsen have consistently refused to criticize the Fed's Republican chairman even while liberal Democrats -- especially Maryland Sen. Paul Sarbanes -- were hammering away.

The key factor to watch now is the long-term bond market. Contrary to the expectations of Fed chairman Alan Greenspan, long-term rates climbed in tandem with short-term rates beginning in February. World markets, in effect, were saying that quarter-point increases were unconvincing -- that U.S. monetary policy was still too expansionary to contain inflationary pressures.

This judgment could also be seen in the continued decline of the dollar against the Japanese yen and the German mark. The Fed even had to organize a 17-nation intervention in the exchange markets to keep the dollar from falling through the floor. But this was not enough. Many economists knew interest rate realignment was necessary for exchange rate stability. A harbinger of the Fed's action yesterday was the decision of the German Bundesbank last week to lower its discount rate by a full half a percent, an uncharacteristic step to bring the two currencies into equilibrium.

Initial reaction on Wall Street to the rise in short-term rates was heartening. The Dow Jones stock average rose 49.11 points and, more important, 30-year Treasury bonds fell 16 basis points to 7.29 percent. If this trend continues, Mr. Greenspan's policies will be vindicated after a rough three months and President Clinton can look forward to a first term marked by sustained recovery.

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