Mr Alan Greenspan and his colleagues at the Federal Reserve are currently facing a bit of a dilemma. Against the backdrop of surprisingly robust economic conditions in the US, fears are growing that the Fed will be forced to perform a volte-face and raise interest rates over the coming months. Such a move could prove to be embarrassing. After all, it was Mr Greenspan who made the observation in the wake of Russia's effective default that the US economy could not be an oasis of prosperity when the rest of the world was falling apart. However, the tone of all recent data releases suggests that the world's largest economy continues to power ahead in almost blissful ignorance of events outside its borders. Rather than grinding to a halt, the economy is now into the ninth year of the greatest expansion in the peacetime history of the US.
In cutting interest rates on three occasions in the second half of 1998, the Federal Reserve was effectively taking a gamble that the trade hit from the emerging markets and fears of a domestic credit crunch would lead to a moderation of growth. That bet has not paid off and, if anything, the US economy has actually picked up momentum since last autumn. Today's revised US growth numbers could put Q4 [the last three months of 1988] growth as high as 6.2 per cent as consumers enjoy the benefits of lower interest rates and ongoing buoyancy in share values. Given the underlying strength of the US economy, as witnessed by solid job creation, an unemployment rate of 4.3 per cent and healthy confidence levels, the reaction of domestic activity to interest rate cuts can hardly be regarded as a shock.
Particular buoyancy has been seen in housing starts, payrolls and retail sales. These areas are highly sensitive to changes in interest rates and can look forward to increased vigour over the coming months as the effects of last year's 0.75 per cent interest rate cut feeds through to the real economy.
The growth potential of the US is underpinned by the relatively closed nature of its economy with estimates suggesting that domestic conditions are the main drivers of some 90 per cent of all sales and jobs. As a result, deteriorating conditions in the country's main trading partners have very limited impact on economic activity at home. Given this imbalance between domestic and external exposures, it is clear that a growth moderation can only be assured through an increase in local interest rates or a collapse in share prices.
Ever since late 1996 when the "irrational exuberance" phrase was first uttered, Fed officials have been concerned about the rude health of the stock market. Given the negative impact of a share-price collapse on both investment and consumer spending, these concerns are somewhat understandable. However, the market, driven by solid domestic fundamentals and the low returns offered by cash and bond products, has continued to power ahead despite these concerns. The Dow Jones now stands some 50 per cent higher than it was when Mr Greenspan spooked the markets with his "irrational exuberance" comment. It appears that a stock market crash is not going to do the Fed's work for it.
Meanwhile, it is no longer safe to assume that the emerging markets will exert an increasing restraint on the developed world this year. While some countries, including Russia, Brazil and Indonesia, are facing further economic contraction, the first shoots of recovery are beginning to appear in Thailand and South Korea. These countries, which were in the frontline of the crisis, have been quietly implementing their IMF-sponsored stabilisation programmes and look set to enjoy reasonable growth rates in 1999.
Some comfort should also be taken from the tame reaction of the key Latin American markets to the collapse of the Brazilian currency. The new-found attractions of sound budgetary management to Brazilian parliamentarians and the pursuit of sensible economic policies in Argentina and Mexico have helped to prevent an outbreak of Asian-style panic in Latin America.
Leaving aside domestic considerations, anxiety about the implications for the world economy pushed the US monetary authorities into easing mode last autumn. In effect, Mr Greenspan, by sanctioning a dramatic loosening of monetary policy, was acting as a global guardian angel. The confidence-enhancing and liquidity-boosting effects of the rate cuts have shored up emerging markets' sentiment and prevented the crisis from becoming a catastrophe. With stability returning to the developing world, the Fed should soon switch emphasis and address the needs of the US economy again. Mr Greenspan himself came close to conceding this point at his Congressional testimony earlier this week when he described the economy as admirable but stretched.
Against a relatively secure international backdrop, the monetary authorities have probably already reached the conclusion that the US economy requires an increase in interest rates. Such a monetary tightening now would allow growth to fall towards more sustainable levels and could reduce the risks of the current boom ending in an unpleasant bust. While a policy reversal may tarnish Mr Greenspan's market status as a demigod, it would help to prolong the extraordinary growth phase in which the US now finds itself.
Colin Hunt is chief economist at Goodbody Stockbrokers.
