Greenspan's Legacy: The "Financialization" of Monetary Policy, Asset Bubbles, and Inflation

The Federal Reserve, led by Fed Chair Alan Greenspan, made a historic policy transition nearly thirty years ago. The Fed abandoned its banking-type money and credit indicators. Instead, it adopted a policy anchor of real interest rates while relying on financial indicators to help assess when the policy is too loose or tight. That was a monumental change from a Fed Chair that once stated, "We are in the business of making money," and the "growth in money and credit has to mean something" for inflation.

Greenspan argued the change in the framework did not change the Fed's mission. The goal was to set real interest rates that create steady growth and minimal inflation and rely on a broad set of financial indicators, such as the yield curve's slope, yield spreads, equity prices, and measures of inflation expectations. The heavy reliance on these indicators started the "financialization of monetary policy."

It is not easy to determine what real interest level is neutral for the economy at any point in time. For one, real interest rates are cyclical, moving up during expansion and down during slower growth periods or recession. Also, changes in labor markets, finance, technology, global factors, and others can move the needle over time.

There is also no standard way how to measure real interest rates. A simple way of measuring real rates is by subtracting reported inflation from the nominal federal funds rate. A 4% fed funds rate, for example, yields a 2% real rate if the rate of inflation is running at the Fed's target of 2%. But some prefer to use inflation expectations in the estimate. There are several problems with this approach. First, inflation expectations are not directly measurable. Second, inflation expectations flow from what people have experienced, so they are backward-looking.

Greenspan's decision to monitor inflation measured against nominal rates did not stop there. The Fed Chair used his political clout to force a statistical change in the measurement of inflation. Greenspan told Congress in the mid-1990s that the Fed staff estimated that the CPI measure overstated reported inflation by 0.5% to 1.5%. Greenspan and the Fed staff only focused on methods that would provide a lower index and overlooked things that would result in an index increase. Nonetheless, that controversy provided a convenient format for a political discussion on a design change to produce a lower index. And Congress forced the Bureau of Labor Statistics to create a lower index.

A lower index of inflation helps the Fed meet its inflation stability mandate. But Greenspan went a step further. In the early 2000s, when the Fed was selecting its preferred inflation index, Greenspan stated that the Fed favored the personal consumption deflator (PCE) over the consumer price index. Being well-schooled in economic statistics, Greenspan knew that the PCE index was not a direct measure of inflation. Moreover, 70% of the PCE prices came from the CPI, an index he argued was faulty, and the remaining 30% came from administered or non-market prices. But, Greenspan got what he wanted, a price series that consistently showed a lower index, and sold a second-class price index to Congress, investors, and the general public.

The change in the policy framework is akin to a builder using a naked eye and instincts to build a house instead of starting with a strong foundation and plan, and that is transferrable to the next generation of owners or policymakers. Without a strong foundation, any structure or monetary system could take

years to develop foundational issues that could cause cracks or even a collapse.

It didn't take long for this policy framework to show cracks and even came close to total collapse at one point. Here's a list of its policy failures:

1. The Fed ignored and overlooked the massive investor speculation and the surge in corporate debt during the dot.com boom.

2. The Fed downplayed the trillions in mortgage debt households borrowed and the rampant speculation during the housing bubble.

3. The Fed did not respond to the record surge in broad money that has helped fuel the most significant general inflation cycle in forty years.

The record of Greenspan's monetary framework is much worse than that of the monetary policy blunders of the 1970s. Yet, most alarming is that the current generation of policymakers still follows the real interest rate framework.

The recent 50 basis point rally in 10-year yields reminds me of a similar rally during the May to June period of 1994. Back then, investors viewed a surge in inventory accumulation as slowing growth and less Fed tightening. Greenspan squashed that optimistic view when he said the buildup was intentional and signaled more Fed tightening. As a result, ten-year Treasuries reversed course and rose 100 basis points.

Likewise, optimism that inflation is peaking nowadays has led to a rally in bonds and equities. Yet, inflation peaking does not mean the inflation cycle is over or even close to the 2% target. Moreover, as long as the money and credit spigots remain wide open, the inflation cycle will run longer than many expect. Even though Greenspan abandoned the monetary science of money and credit in the 1990s does not mean they still don't matter. The events since 2000 tell us they matter a lot, and hopefully, the next generation of policymakers will revisit the money and credit targets of yesteryear.