Greenspan Proves Fallible

“I was adored once . . .,” one of Shakespeare’s characters sighs to another in Twelfth Night. Alan Greenspan must be having similar thoughts as he faces the new-born enmity of the bond investors who once worshipped him.

The Federal Reserve Board chairman, the man who warned of “irrational exuberance” when others thought that share prices merely reflected animal spirits unleashed, and who manipulated monetary policy so as to prevent the bursting of a share-price bubble from turning America into deflation-ridden Japan, suddenly finds the pedestal on which he has been perched by the public to be a bit shaky.

The fall from grace began when Greenspan had the temerity to disappoint the expectations of the bond market. Investors had been led to believe by the “usually reliable press sources” that he would lower interests by half-a-percentage point. But he and his monetary policy colleagues reduced rates only by one-quarter of a point. Bond investors felt that the punch bowl had been yanked from them just when the party was at its peak. After all, they had persuaded themselves that “a Greenspan put” assured them of ever-increasing gains on their investment.

Then last week a newly cheery Greenspan told Congress that he expected the economy to grow at an annual rate of between 3.75 and 4.75 percent next year. Growth at that rate, Greenspan suggested, could be maintained without triggering inflation because there is enough slack in the economy to prevent stepped-up activity from forcing an increase in prices.

The prospect of low inflation should have encouraged bond holders, because in the absence of a bout of inflation the Fed would be able to keep interest rates low and (the obverse) bond prices high. But they were not pleased. Investors in bonds, especially those with longer maturities, decided that so robust a growth rate would bring an end to an era that has seen the Fed cut short-term rates from 6.5 percent to 1 percent in thirteen successive steps, and would force Greenspan to begin raising rates, forcing bond prices down.

So after the Fed chairman testified, bond prices dropped by an unusually large amount. The price of the Treasury’s ten-year IOUs fell, driving the yield up to around 4.00 percent from 3.73 percent a day earlier. Gone are the days when Greenspan’s public musings about the threat of deflation led investors to buy bonds in the belief that their prices had nowhere to go but up. No one can be as angry as an investor whose expectations, no matter how unreasonable, have been disappointed. Greenspan, they concluded, had let them down. No more adoration for him.

The chairman then compounded the felony by saying that he would do whatever had to be done “for as long as it takes to achieve a return to satisfactory economic performance.” He meant, of course, that he would keep interest rates low, and lower them again if need be. That should have brought cheers from bond investors.

But they preferred to see their glass as half empty. A more rapidly growing economy—Greenspan’s stated goal—would create pressure on him to raise interest rates, lowering bond prices. Indeed, the report that retail sales in June increased at the second fastest rate so far this year; news from The Institute of Supply Management of pickups in new orders, backlogs and employment in non-manufacturing industries; reports that capital spending on information technology equipment and housing construction are increasing; and a government announcement that output in the beleaguered manufacturing sector increased in June for the second straight month, all suggest that a period of sustained growth may already be underway.

In light of this evidence, the Business Cycle Dating Committee of the National Bureau of Economic Research—charged with calling cyclical turning points, not with lining up dates for lonely economists—decided late last week that, despite a still-weak labor market, the recession that began in March of 2001 ended only eight months later.

Even traditionally gloomy CEOs are starting to believe that the worst is over. They told the Conference Board that their confidence in an economic rebound is increasing, and the CEO-only Business Roundtable reports a “modest but measurable” improvement in the outlook for spending by the nation’s largest companies, proving that there is nothing like a rise in share prices to buoy the spirits of corporate moguls.

To make matters worse for bondholders, who dread the inflation and interest rate increases that are associated with economic recoveries, Secretary of Commerce John Snow has been in Europe trumpeting the better times that are just around the corner. In an exclusive interview with The Times, Snow said, “The American economy is coiled like a spring and ready to go.” He estimates that the economy is now growing at an annual rate of 3 percent, and will accelerate to a rate “comfortably above 4 percent” next year, bringing the unemployment rate down from its current level of 6.4 percent.

The final bit of bad news for the bond markets was the report that the budget deficit has taken off and will be $455 billion in this fiscal year and $475 in the next. That is close enough to 5 percent of GDP to worry those who think that a new flow of government bonds will drive down the price of all such IOUs.

Add those positions up, and you get a bondholders’ nightmare—loose fiscal policy in a period of accelerating economic growth, and a Fed chairman willing to risk some inflation in order to stimulate growth at a rapid enough rate to sop up excess capacity. Investors are now hoping that the pin Greenspan has stuck in the bond bubble will result in a slow leak, rather than a big bang.

This article appeared in London’s Sunday Times on July 20, 2003.