JACKSON HOLE, Wyo. - Federal Reserve Chairman Alan Greenspan made it clear yesterday that human judgment should reign in the central bank's interest-rate decisions if it is to act swiftly against potential economic risks.
In a speech at a Fed conference here, Greenspan argued against proposals that would force the Fed to use a hard-and-fast rule, such as changes in a specific inflation rate, to decide when and how much to change interest rates.
Greenspan said the Fed has deliberately shied away from a specific rule to set interest rates because one couldn't adequately respond to economic uncertainties.
For example, he said, the central bank now is seeking to control deflation even though most conventional economic models on which a rule might be based "would not project such an event."
Many critics of Greenspan's 16-year career at the central bank would like to see a less personalized decision-making process by the Fed after he leaves, arguing that the chairman has erred at critical points by raising interest rates, which harmed the economy.
Greenspan had, in fact, became an economic leader of so much celebrity that the market's fortunes were at times affected by his every utterance or offhand remark.
The support for a formal inflation target to guide Fed policy is gaining support, said Lyle Gramley, a former member of the central bank. But he said that as long as Greenspan is chairman, it is not likely to happen. After he leaves, it could be adopted, he added.
Specific figure
An inflation rule would work something like this: The Fed would announce a specific inflation figure that it wanted to maintain over the long run - say 1.5 percent to 2.5 percent. When official inflation figures moved too low, the central bank would cut interest rates. When they rose above it, they would raise interest rates.
There are variations on this kind of rule being advanced by economists.
Adoption of a formal rule would fundamentally change the nature of Fed monetary policy, which has been largely flexible for much of its 90-year history. Indeed, the Fed chairman is called the "second-most-powerful official" in Washington and is widely seen as both an economic and political figure who must answer for the economy's broad performance.
Greenspan has made mistakes in his career, said Michael Drury, chief economist of McVean Trading and Investments in Memphis, Tenn., but adopting a formal inflation target "would be a difficult thing to sell" to the public.
John Silvia, an economist at Wachovia Securities and a Greenspan admirer, said financial markets want to see the Federal Reserve adopt at least some guidelines for monetary policy so that market participants would have a clearer idea of where the Fed is headed.
"I don't see a clamor in the market for a rule that Greenspan spoke against," he said, "but I think there is a desire for some kind of guideline" that the central bank could announce it is generally seeking to achieve.
But Greenspan said he wanted nothing of a mechanical, mathematical approach linked to changes in monetary policy, which has a broad impact on the economy and around the world. He said it was "highly doubtful" that such an approach would lead to better economic performance, since some economic indicators are often replete with error.
In effect, he said, making monetary policy is an art, not a science.
He favored the current flexibility and discretion of Fed members in which they "draw from broader, though less mathematically precise, hypotheses of how the world works" and can deal with the remote, though extremely dangerous, prospect of deflation, or falling prices.
The central bank has no real restrictions on its interest-rate policies, which are often debated hotly by Federal Reserve members.
The Fed currently conducts its policies by setting a target for the overnight lending rate that banks charge each other for loans. It then pumps money into the economy to ensure the interest rate remains at that designated target.
Changing conditions
Though the issue over a hard-and-fast rule is seemingly arcane, it carries particular weight in financial markets where many analysts now say they are having a hard time figuring out Fed policy with interest rates so low.
Indeed, when the Fed last cut short-term interest rates, long-term bond rates rose because many in the market felt that inflation might kick up as a result. Silvia said markets now want to see the Fed name some specific inflation rate as to what it would consider to be too low.
Fred Breimyer, chief economist at State Street Bank in Boston, said Greenspan made clear that "he had no ability to adopt a rule-based monetary policy because the economic conditions are constantly changing."
Yet, he said, the time may come after Greenspan retires that the central bank will adopt such a rule.
The Chicago Tribune is a Tribune Publishing newspaper.
