BY ALLEN TYE

The last five years, culminating with the events of Spring 2001, have been extraordinarily confusing and tortuous for the members of the Federal Reserve. Flash back to 1997: The economy is healthy, the Nasdaq and the Dow Jones Industrials had shown modestly impressive growth to1700 and 8100 respectively. The Federal Reserve publicly expresses confidence in gold and commodity prices as early indicators of any looming inflation. But all is not well: rapid declines in commodity pricing across the board stress Asian capital markets, and in the summer of 1998 the Russian economy unexpectedly cracks under the burgeoning weight of a strong US dollar coupled with declining oil and gold prices, Russia&Mac226;s primary sources for trade revenues. The Federal Reserve responds in textbook fashion, reducing the Fed Funds rate in 3 rapid successive rate cuts, and in the fourth quarter of 1998 the markets respond with one of the best performing periods in history.

Still, all was not roses within the Federal Reserve. Having narrowly averted one financial calamity, they possessed a lingering concern over what they perceived as another: America&Mac226;s unemployment problem. Simply put, there was not enough of it. Unemployment rates dropped below 5%, igniting expectations of wage inflation as employers found fewer sources of cheap labor. And so in 1998 the Fed significantly adjusted their monetary focus away from commodity metrics as they uneasily eyeballed a US workforce in full gear. In 1999, that fully deployed workforce combined with productivity gains associated with a silicon economy caused an upward explosion of capital market valuations as investors pondered the implications of high economic growth rates in an expected environment of little or no inflation. The Dow broke through 11,000 and the Nasdaq astoundingly broke through 5,000, peaking at 5132 in January of 2000. The new millennium had arrived, and the Federal Reserve suddenly was faced with the unique condition of surging markets devoid of incipient inflation, contrary to virtually all conventional wisdom. Convinced that some action had to be taken, despite the lack of clear inflationary signals, the Fed created the relatively novel "wealth effect" concept that employed the financial markets themselves as an inflationary proxy, the rationale being that people with stock market gains would embark on a spending surge that would finally trigger the expected inflationary pressures. Thus, relying on historically suspect metrics (employment numbers and GDP growth) and novel "intuitive" metrics (market-induced wealth inflation), the Fed raised the target fed funds rate to ward off an inflation that amazingly never emerged. In the process, they helped stop the strongest economy in economic history dead in its tracks.

In retrospect, the Fed was wrong in their expectations of inflation. After all, it was as late as December 18, 2000 that they were still making policy pronouncements diligently and erroneously oriented towards preventing inflation by curbing economic growth. The effort to cool the economy through higher capital costs suddenly descended into an apparent economic ice age as the markets experienced, beginning in May 2000, what in many ways has become the most wrenching market turbulence since the black October days of 1929. In adapting to conditions that they had never before faced (and in fairness, who had?), the Fed fundamentally altered the way the game had been played, disregarding declining commodity prices that traditionally have been important benchmarks of monetary stability while using financial markets as policy tools only on the upside without factoring the financial market's relevance to monetary policy on the downside.

The good news is that the Fed has returned to more conventional policies. On January 4, when announcing the first rate cut, Alan Greenspan observed that this is now an economy that can grow at 4% without inflation, setting the table for four subsequent rate cuts heading into the June 27 Fed meeting. And while the economy has yet to show significant signs of recovery from the liquidity constraints of past Federal Reserve policy, continuing Federal budget surpluses, declining interest rates, a tax cut, and increased options on IRA savings plans can offer solace to investors who are willing to look past the current dog days of summer.