by John M. Curtis
(310) 204-8700

Copyright July 2, 2004
All Rights Reserved.

atcheting up the federal funds rate a quarter percent to 1.25%, Federal Reserve Board Chairman Alan Greenspan is poised for his last act of demolition before his scheduled retirement in 2006. It was, after all, Greenspan's warning in 1998 about “irrational exuberance” that led to his relentless rate hikes that torpedoed the last bull market, eventually causing the worst stock market crash in March 2000 since the great depression. Investors watched their portfolios—including 401K and IRA retirement accounts—go up in smoke, losing, in some cases, 90% value. Despite the market's modest turnaround since bottoming out in March 2003, many investors still haven't recovered massive losses from the last meltdown. With the economy still on wobbly legs, Greenspan's latest move ignores the bigger picture, focusing instead on abstract number crunching.

      Another market crash would have devastating consequences on personal and corporate liquidity, using, once again, unemployment to fight inflation. Inflation poses a far less risk to the nation's economic health than pulling the rug out from underneath the stock market. Despite recent progress, the tech-rich Nasdaq is still only 40% of its past glory of 5,000, hovering around 2,000. Even the Dow Jones Industrials is still 16% off its all-time high of February 2000. Rocking the markets now with a series of unwarranted rate hikes promises to repeat Greenspan's past mistakes. Not only will rate hikes sabotage the stock market but it promises to undermine the nation's real estate boom, responsible, far more than tax cuts, for supplying the cash needed to expand the economy. Hiking rates might reduce inflation but it could lead to bankruptcies and mortgage defaults.

      Raising the federal funds rate—the rate banks charge each other for overnight loans—immediately boosted the prime-lending rate to 4.25%, low by historical standards yet the right elixir for an anemic economy. Jumping credit card and home equity rates hurts consumers by increasing monthly overhead. Paying more interest to financial institutions rather than consumer goods and services won't help the economy. If the Fed gets its way, it's going to push the federal funds rate to 3-4%, boosting the prime to 7-8%, potentially pushing mortgage interested rates to 9%. Individuals currently with low monthly payments would find themselves unable to meet monthly obligations leading to defaults and bankruptcies. “It's not going to be a deal breaker for most people,” said Edward F. McKelvey, an economist with Goldman Sachs, not too worried about the Fed's current move.

      Most Fed watchers expect Greenspan to continue hiking rates over the next 18 months, barring an unforeseen cataclysm, pushing the federal funds rate up to a neutral level with regard to stimulating the economy. Fighting inflation is only one aspect to Greenspan's latest rate hikes. With Europe's central bank raising its benchmark rates, the Fed must keep pace, or, as it's seen in recent years, watch a steady exodus of foreign investment out of U.S. treasuries. Current treasury yields are not competitive with European rates, forcing the Fed's Open Market Committee to begin squeezing capital markets. Although President's Bush's tax cuts provided some stimulus, it was the Fed's historically low rates that helped the U.S. economy recover from corporate scandals and terrorist attacks. Raising rates now encourages more foreign investment but hurts the overall economy.

      Blaming current rate hikes on only inflationary pressures ignores the Fed's own liquidity crisis. When foreigners—as well as domestic investors —don't buy U.S. treasuries, it shrinks the federal treasury. Offering more attractive rates entices foreign and domestic investors to buy U.S treasuries. Savings rates have been abysmally low with the federal funds rate hovering at 1%. Hiking rates encourages more investments in U.S. treasures but potentially risks dropping tax revenues by increasing unemployment, hurting the stock market and crippling the economy. Keeping rates low also encourages investors to keep capital working in the stock market. Increasing yields on fixed-income securities discourages investing in the more risky investments. Greenspan's last miscalculation cost the U.S. economy $4 trillion in corporate and personal wealth—something today's economy can't afford.

      Before Greenspan gets too cocky and makes the same mistake, he should consider the fallout of sabotaging today's fragile stock market. Where's the liquidity suppose to come from to fuel economic expansion and more jobs? Today's jobs report already shows a slowdown in hiring, from the modest pace witnessed during the second quarter. “The economy is strong and growing because of the polices the president put in place . . . I think it's always expected that a rate increase would be part of that strengthening of the economy,” said White House press secretary Scott McClellan, implying Bush's tax cuts got the economy running on all cylinders. With tax cuts eaten up soaring gas prices and now increased installment debt, it's doubtful more tax-cuts—especially in light of whopping deficits—can rescue the economy. Greenspan needs to come to his senses before it's too late.

About the Author

John M. Curtis writes politically neutral commentary analyzing spin in national and global news. He's editor of OnlineColumnist.com and author of Dodging the Bullet and Operation Charisma.

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