The Ghost of Greenspan

It’s haunting the Fed.

Ben Bernanke. Click image to expand.
U.S. Federal Reserve Chairman Ben Bernanke 

The markets have been somewhat choppy since Chairman Ben Bernanke took the helm of the Federal Reserve in February. The Chicago Board of Options Exchange’s volatility index, a useful gauge of traders’ nerves, is up nearly 50 percent in the last few months. Several factors are contributing to the greater volatility—a resurgence of inflation, hot money flowing in and out of emerging markets and speculative sectors, the housing slowdown. But perhaps the most important cause is Bernanke himself—in particular his handling of inflation and interest rates.

Alan Greenspan, a slayer of inflation and a sure-footed oracle, learned to play the markets even better than he played the saxophone as a teen. But Bernanke is still feeling his way into the job. And when it comes to combating inflation—the chief role of the Fed—Bernanke’s horn has been wavering. Bernanke came in with a reputation for being soft on inflation, in part because of this November 2002 speech on the dangers of deflation. As Fed chairman, however, Bernanke has generally been hawkish on inflation. After being sworn in on Feb. 1, he continued Greenspan’s rate-hiking campaign, which began in the spring of 2004. The Fed has now boosted the Federal Funds rate by 25 basis points at 16 straight meetings, lifting it from 1 percent to 5 percent. Bernanke has also bent over backward to tell people not to underestimate his resolve to combat inflation. In late April, while chitchatting with CNBC anchor Maria Bartiromo at the White House Correspondents Dinner, he said that investors were mistaken if they thought the March 28 rate increase would be the last. He later apologized for the indiscretion. On Monday, the markets tanked in part because Bernanke delivered a toughly worded speech about inflation, hinting that rates could continue to rise. And yet his message hasn’t been consistent. Check out this excellent column by Liz Rappaport on for a catalog of Bernanke’s varying statements on inflation.

But Bernanke’s rhetorical vacillation isn’t the Fed’s sole contribution to the recent volatility. It’s his new methods. Last week, Bernanke told a Senate committee that economic data released in the coming weeks would help determine whether the Fed would raise rates at its next meeting at the end of June. “Our thinking on this will be very data-dependent.” Now, the Fed has always been “data dependent.” But the implication of Bernanke’s comments was that the Fed would essentially make decisions on the fly, based on the latest headlines. So, every time a new piece of information comes in, like last week’s lame jobs figure, investors have to guess at how that might impact the Fed’s decision. The fact that economic data are frequently contradictory contributes to investors’ confusion.

In theory, this type of transparency and disclosure was precisely what the market wanted from the new Federal Reserve chairman. For years, investors have complained that Greenspan’s Fed was too opaque, too hard to read. But now it turns out that trying to interpret public data is even trickier than interpreting the oracular Greenspan.

The Bernanke-era volatility can also be blamed on the stature gap. Under Greenspan, the Fed generally spoke with a single voice, Greenspan’s, and didn’t engage in any public debate. Sure, the other Fed governors and heads of the Fed’s regional banks were well-respected economists. And, yes, their testimony and comments were dutifully reported by the financial wire services and picked over for clues as to what the Fed might do next. But they were like so many planets to Greenspan’s sun. Today, as would have been the case regardless of Greenspan’s replacement, Bernanke lacks Greenspan’s weight. And as a result, the comments of people who were perceived as peripheral players in the past now have a greater capacity to move the markets.

Today’s Wall Street Journal, for example, features a large article in the front section that contains snippets from an interview with William Poole, president of the Federal Reserve Bank of St. Louis, who said the Fed needs to maintain “an upside bias” to ward off inflation. (Translation: More interest-rate hikes could be in the offing.) But it also contained quotes from Federal Reserve Gov. Susan Bies, who said that while she isn’t pleased with the current inflation rate, the recent interest-rate hikes are still “making their way through” the economy; and a quote from Kansas City Fed President Thomas Hoeing, who echoed the lag comment. (Translation of Bies and Hoeing: We might be done raising interest rates.) We rarely heard so much dissension under Greenspan—and if we did, the only voice that was heeded was the Maestro’s. Today, the confusion over what to do seems evident within the Fed’s own conference rooms. The minutes from the Federal Open Market Committee meeting of May 10, which were released May 31, showed that the discussion ranged from holding rates steady to raising them by 50 basis points—a huge divergence of opinion by recent standards. More data, less certainty.

To aggravate matters, Bernanke is still operating under the shadow of his predecessor. Greenspan’s musings on the economy still carry weight in the marketplace. The lead story on Yahoo! Finance this morning, for example, was an article on Alan Greenspan’s testimony before the Senate foreign relations committee about the impact of high energy costs on the U.S. economy. (The Maestro thinks it may be finally taking a bite out of growth, which would seem to suggest that the Fed should be wary of raising rates further.)

Getting monetary policy right is an enormously complicated and difficult task. And because interest-rate hikes and cuts take a while to fully work their way into the economy, the Federal Reserve generally has a tendency to overshoot—it frequently cuts rates after the economy is growing and frequently raises rates even when the economy is slowing. Greenspan’s decision to leave rates so low for so long set into motion the processes that may compel Bernanke to continue raising them. Someone has to choke off the excess liquidity that Greenspan unleashed on the world in the early years of this decade. And as he attempts to compensate for Greenspan’s legacy of opaque communications and a monolithic Fed, Bernanke may be unsettling the markets he wants to calm.