Looking forward to his upcoming retirement, Alan Greenspan is taking advantage of two things during his last few months: Beautiful scenery and bombshell last words.

This weekend’s conference in Jackson Hole, Wyoming was no exception. Against the backdrop of one of the world’s most pristine ski resorts, Greenspan gave a heart-warming farewell address to a chummy group of central bankers, academics and Wall Street investors.

Within the seemingly innocent and personal address, however, Greenspan managed to pack a statement about Fed policy that not only shook the invitees in this sleepy resort town but had financial communities around this world buzzing all weekend.

As arguably the most influential voice in the world’s economy, one might wonder what words the guy would choose as part of his big exit. Was it “Dump your bonds”? “Bush has back-taxes”? “Fort Knox’s security code is 5472”…?

Alas, none of these were it. The last words that Greenspan actually chose were these:

“Fed policy will be ‘increasingly driven by asset-price changes’ such as rises or declines in prices of stocks and houses”.

Kind of dull, right? Or is it?

In fact, this statement just happens to raise two of the biggest issues currently debated among central bank players.

The first issue that this statement brings up is the desire to have central bank policy rules in the first place. A central bank has a couple of options to do its job. It can be very transparent and tell the world what targets it has and what formulas it uses to achieve those targets. An example of this is: “We will always aim for exactly 2% inflation.” This can be a good way to avoid surprises when changes are made. However, it leaves less room for flexibility. If the central bank wants to deviate from historical or stated practices, any departure might cause a lot more turmoil if markets expect what it’s been promised. The other option is to not be so open. If no rules are stated then none are ever broken.

Greenspan’s team has been less rule-based in the past, so his statement is a clear sign of departure from what people are used to.

The second issue is, if there is a target, what should that target be? As many people know, many central banks direct monetary policy based on inflation rates. When inflation is too high, the central bank raises lending rates, making it more expensive to borrow (and therefore spend) money. When inflation is low, the Fed lowers the rate to catalyze spending to encourage companies to hire more people. Seems pretty simple.

But some economist argue that nominal inflation is the wrong way to go. This was a great target a couple of decades ago when inflation was rampant in many places and everyone just wanted price stability. But now, with inflation being “fixed” (mitigated to about 2-4%) in most industrialized countries, inflation has taken a quiet exit and “bubble” is the new buzzword.

Asset prices could be an alternative target for the Fed in today’s situation. For example, if the main issue keeping bankers awake at night is inflated housing prices (or, a few years ago, inflated stock prices), why should the Fed put its “inflation” blinders on and ignore what’s really important? Why doesn’t it target housing prices: when they’re too high lending rates should go up, and when they’re too low rates should come down. This strategy might seem a whole lot more relevant in today’s time.

The problem here, though, this assumes that the government knows when prices are “too” high or “too” low. And, as the demise of centralized economies under communism showed, governments are not the best at price fixing. They just simply cannot process all the necessary information to determine what prices “should” be the way that markets can.

So these words of Greenspan, which jump onto radically different sides of these key debates from the status quo, don’t seem so bland anymore. Sure the code to Fort Knox would have been pretty cool, but, come on. A cool economist? That would just be creepy.

Posted by Michelle Smith on August 29, 2005 05:30 PM