The Daily Reckoning PRESENTS: Thus far, the current Fed
chief's "wily gamesmanship" has seen him through the
bursting of one bubble - the late '90s stock market mania -
relatively unscathed. But just how far can his words reach?
The good doctor reports, below...
AN OPEN MOUTH
By Kurt Richebächer
The people who expect a double dip or worse in the United
States certainly represent a small minority. Among
policymakers and economists in America, it is a virtual
consensus view that the Great Depression of the 1930s as
well as Japan's present, protracted economic quagmire have
their decisive cause in one crucial policy mistake: both
central banks were much too slow in lowering their interest
rates when the economies began to weaken.
All this really boils down to one key question: When do
central banks make their decisive mistake? Is it during the
boom and the bubble? Or is it in their aftermath?
Convinced he had learned from history, Mr. Greenspan
slashed the Fed's federal funds rate with unprecedented
speed from 6.5% to just 1%. Establishing thereby a steeply
sloped yield curve, his aggressive rate cuts had sweeping
effects also on long-term rates, as investors and
speculators stampeded into highly leveraged purchases of
higher-yielding longer-term bonds.
In principle, central banks have but two instruments at
their disposal to influence money and credit growth with
the ultimate aim to curtail or to stimulate economic
activity: adjustments in bank reserves through open market
operations; and adjustments in its key short-term rate or
rates.
Yet there is still a third, unconventional instrument of
which central bankers have made very different or no use of
at all. It has sometimes been called a central bank's open-
mouth policy. Mr. Greenspan is definitely the world's one
central banker who has practiced this extraordinary tool
with unusual abundance and aggressiveness. He, apparently,
regards it as perfectly legitimate for a central banker to
bend expectations in the economy and the markets in a
direction he wants.
During America's boom and bubble years, Greenspan was
effectively the most prominent and also the most pronounced
New Era Apostle. In various speeches, he developed
arguments or "theories" plainly rationalizing and fanning
the euphoria in the stock market.
In his famous Boca Raton, Fla., speech on Oct. 28, 1999,
just a few months before the stock market's crash, he
suggested that the unprecedented equity valuations seemed
to be the appropriate response of investors to the
economy's advanced information technology:
"The rise in the availability of real-time information has
reduced the uncertainties and thereby lowered the variances
that we employ to guide portfolio decisions. At least part
of the observed fall in equity premiums in our economy and
others over the past years does not appear to be the result
of ephemeral changes in perceptions. It is presumably the
result of a permanent technology-driven increase in
information availability, which by definition reduces
uncertainty and therefore risk premiums. The decline is
most evident in equity risk premiums.
"But how long can we expect this remarkable period of
innovation to continue? Many, if not most, of you will
argue it is still in its early stages. Lou Gerstner (IBM)
testified before Congress a few months ago that we are only
five years into a thirty-year cycle of technological
change. I have no reason to dispute that."
Having learned nothing from his past blunders, Mr.
Greenspan is at it again. To quote Fed mandarin Vincent
Reinhart: "The Federal Reserve has always appreciated the
importance of correctly aligning market expectations."
Putting it rather more bluntly, the Fed endeavors "to
manipulate market expectations in the direction that the
Fed desires."
During the late 1990s, Mr. Greenspan was keen to foster the
stock market bubble by aggressively manipulating both
market rates and market perceptions. After the equity crash
of 2000, he has become keen to foster the three new bubbles
he kindled in fighting the burst of the stock market bubble
- the house price bubble, the mortgage refinancing bubble
and the bond bubble.
Together, these bubbles are plainly indispensable for
maintaining some zip in consumer spending.
But among the three bubbles, one is of crucial importance
because it drives the other two. That is the (now hard-
pressed) bond bubble. Refinancing activity tends to pick up
significantly whenever mortgage rates drop below previous
lows. Importantly, Treasury yields guide the movements of
mortgage rates. In essence, it was the sharp drop of
Treasury yields over the past two years that led the
simultaneous, steep decline of mortgage rates. The recent,
renewed sharp drop in Treasury yields gave mortgage
refinancing another strong boost.
Within barely six weeks, 10-year Treasury yields plunged
from close to 4% to close to 3%. In sympathy, mortgage
rates fell to 5.21%, the lowest rate in more than four
decades.
The astonishing thing about this sudden decline in market
interest rates was that it happened at a time when the
stock market was, on the contrary, being carried upward by
spreading hopes for the economy's imminent recovery. What
happened to make this new, sharp decline of longer-term
interest rates possible?
In its May 29 editorial, The Wall Street Journal praised
the Fed chairman for his wily gamesmanship. "Merely by
talking about deflation, he's made the markets anticipate
easier money; long-term interest rates have fallen
accordingly, helping to keep housing prices afloat and to
spur one more round of home mortgage-refinancing. This in
turn feeds consumer confidence and helps keep the post-
bubble economy growing. As a monetary gambit, uttering the
word deflation has so far been a great tactical success. We
suppose that's worth the price of scaring people about an
economic threat that isn't very likely."
In short, being assured by Mr. Greenspan and other Fed
members that there would be no interest rate hike as far as
the eye can see, investors and speculators, desperately
hungry for big profits, stampeded into heavily leveraged
bond purchases, giving through the sliding yield a new
strong boost to mortgage refinancing.
Closer to the truth: In the guise of worrying about the
evil of deflation, Mr. Greenspan signaled to the
marketplace his determination to accommodate unlimited
leveraged bond purchases. Investors and speculators
complied with enthusiasm, giving long-term rates another
sharp downward tick. Implicitly, in a country with negative
national savings, any decline in market interest rates can
only come from financial leveraging.
In this way, the last bit of restraint on financial
leverage and speculative excess in the markets was
effectively removed. Endless liquidity is available for the
taking by the speculating financial community. The obvious
result is a credit and bond bubble that meanwhile has
vastly outpaced the excesses of the equity bubble.
The fundamental dilemma today is that - by every method
available - the Greenspan Fed and Wall Street are making
desperate efforts to sustain unsustainable bubbles. Of
these, the belabored bond bubble is now our greatest fear.
Its influences have pervaded the whole economy and the
whole financial system, and its bursting may have
apocalyptic consequences.
Regards,
Kurt Richebächer
for the Daily Reckoning
P.S. Nobody questions the need for action. But it should be
clear that easy money can only be the cure for tight money,
not for any other causes depressing the economy. For us,
the real and disturbing story about the U.S. economy is
that with all its imbalances it has reached the stage where
it requires permanent, massive monetary and fiscal stimulus
to garner just a tepid economic response - and to prevent
the various bubbles from deflating. All this is definitely
not prone to create a healthy economy being capable of
self-sustaining growth.