Is That Really You, Alan?

By Bernard Baumohl

Q. How many Federal Reserve chairmen does it take to change a light bulb?

A. One. Greenspan holds the bulb, and the rest of the world revolves around him.

That joke, making the rounds on Wall Street, is a not-too-subtle poke at Federal Reserve boss Alan Greenspan, who has recently offered some unusual--even heretical--views on why he'll continue to raise interest rates to slow things down.

The apostle of the new economy is now citing increasing productivity as a source of inflation. To many economists, it's like saying vitamin C causes colds. The chairman is also concerned that we're feeling a little too cocky these days and spending too much of our stock-market wealth. He's gone so far as to suggest that stock prices should not rise more than the growth of the overall U.S. economy--in other words, less than 10%.

No wonder his fellow economists and some politicians have suddenly started to question the emperor of the economy. "You know, we're told to get productivity up. We get productivity up," said an exasperated Senator Paul Sarbanes. "The inflation prediction is very good. And yet the Fed is moving to tighten money to slow down the economy." Yes, it is, Senator.

It all started during Greenspan's latest congressional testimony. At first he repeated his usual concern that the economy is expanding too fast. And for the past half-year, it has indeed grown at a red-hot 6% annual rate, double its presumed speed limit and thus an inflation risk as demand for both goods and labor threatens to outpace supply.

But then Greenspan touched off a firestorm by arguing that today's technological innovation and improved efficiency can themselves ignite inflation. His logic? Strong productivity growth raises the outlook for corporate profits, which drives the stock market higher. As equity prices soar, Americans feel wealthier, and that encourages them to continue their wild shopping spree. "The problem is that the pickup in productivity tends to create even greater increases in aggregate demand than in potential aggregate supply," says Greenspan.

This logic turns the new economy philosophy on its head. "This is new," says Lawrence Kudlow, chief economist at Schroder & Co. "No government official has previously argued that rising productivity causes inflation and therefore should be reduced." Most economists fervently believe that rising productivity, led by advances in computers and software, is an inflation killer and that there is no such thing as too much productivity growth.

Then came Greenspan's second blow. He suggested that stock prices ought to rise no more than household income, or about 5% to 6%, to help keep spending in check. It's a mutinous thought to investors who are used to having an annual double-digit jump in their portfolio.

The bottom line: the chairman has changed the rules of the game. Even in the absence of any inflation, Greenspan may now referee not just how fast the economy can grow but also how much stock prices and productivity can rise. It's a clear signal that interest rates will continue to move higher until the economy shows tangible signs of yielding. Since June, the Fed has raised overnight rates four times, to 5.75%, the highest level in four years.

Wall Street economists are baffled by Greenspan's thinking. "If the wealth effect continues to boost demand, then why can't productivity continue to boost supply?" asks Edward Yardeni, chief economist of Deutsche Bank. The mere absence of inflation suggests that productivity is doing the job of keeping consumers happy. But if the chairman is intent on reversing some of the bull market, look out. His speeches and rate increases have already unnerved some investors. Despite Friday's jump, the Dow Jones industrial average closed the week at 10,367, down 10% so far this year. The S&P 500 index is down 4%.

But the high-tech-heavy NASDAQ is up 20% this year and hitting new records virtually every week. Those investors have a message of their own: Give us back the old Greenspan.