A tad askew from the traditional view

Sunday, August 28, 2005


The winter wind swirled around the capitol dome and skipped off toward Foggy Bottom. Inside, the assembled senators listened attentively as Alan Greenspan proudly told them that conditions in the United States might soon be "entering an economic mode that would be the functional equivalent of the Promised Land." This was February, 1995, and the economic mode he referred to was, in fact, the Fed Chairman's long held desire for a world without inflation.

In the intervening years, history has shown that, by his own definition, Mr. Greenspan has been very successful. Inflation has never been lower during the post war period. The main beneficiary of this policy has been the business community. The resulting extended period of low interest rates has enhanced net earnings by reducing this particular operating cost to its lowest level in decades. Unfortunately, top management and major stockholders constructed a dam across the trickle-down theory, and the benefits of the Fed's policy have not been shared by the American worker. Furthermore, the abnormally low interest rates have created an unnatural real estate boom and an orgy of real estate borrowing that has fueled the economy with false expectations.

However, this is not about the lack of job security in the workplace, nor is it about "The Bubble." This article is about the coming recession which is likely to roll in like Desert Storm, a number of months after the Fed Chairman's retirement in January.

Looking back at Greenspan's tenure, it is of some current significance to recall that within weeks of his taking office in August of 1987, it had become clear that the Fed Chairman was going to tighten the money supply to the point of creating an inverted yield curve, a somewhat unusual occurrence in which short term rates actually exceed the levels of long term rates. At that time, I found myself looking at the post war history of such situations, and saw that in each of the nine times that an inverted yield curve had been achieved since 1960, a recession followed on an average of about two years later. Incidentally, this is further evidence of the well known fact that the Fed's policies take time to work their way through the economy and produce results. Anyway, there was also an episode in which the yields became inverted back in the fifties, and in that one situation, there was no subsequent recession. This is understandable, however, because the economy had generated a tremendous momentum at that time, following, first the depression, and second, World War II. The resulting pent up demand for goods, services and real estate could not even be dampened by the extreme measures of the Federal Reserve Board in that instance.

After looking at the history, I take no credit for the fact that, in November of 1987, I pointed out to my clients the fairly obvious conclusion that the economy was on track to experience an inverted yield curve, starting around February of 1988, and that, based on past experience, a recession would develop by 1990. My clients were commercial real estate developers and operators, and I was simply recommending that they pursue adjustable-rate financing at that time, in anticipation of a general lowering of long term rates during the course of the anticipated recession. In point of fact, the inverted yield scenario did begin in February of 1988 and a severe recession did commence in 1990. Some may recall Donald Trump stating that his goal at that time was just to "stay alive, 'til '95" (and he did). The actual data that confirms the existence of a recession is always subject to a delay before it becomes known. It was of interest to me at that time that the Fed was still denying that there would be any recession as late as two months after it turned out that it had already started. So it's fair to say that the Fed's pronouncements are not always gospel and, like everyone else, they make mistakes - only their mistakes affect everyone.

It is becoming increasingly clear at this time, in the last week of August, 2005, that the Fed is hell bent on taking us into another period of inverted yields. However, it's possible that what has happened here is that Greenspan initially misjudged his ability to indirectly force up the long term rates, an objective he undoubtedly wanted to achieve so as to slow down the housing market. And, indeed, it is unusual that the Fed's tightening in the short term market has had no effect on the long term market. The Fed Chairman refers to this anomaly as a "conundrum," and by using that term, he is essentially admitting that he misjudged the situation. And vexing this must be, for once the Fed realized that its policy wasn't working, it was faced with a dilemma - to continue tightening or not. But the fact is that once the Fed establishes a course of action and announces its intent, any drastic change is interpreted with a degree of panic in the always nervous financial community, so the Fed has little choice, in the face of its admitted miscalculation, but to proceed boldly onward into what I would characterize as unknown territory.

Early last week, the spread between the yields on the 10-year government bond and the two year note slipped below 20 basis points for the first time in this economic cycle, and by week end, the spread was down to 12 basis points. Based on current trends and historical precedent, a full blown inverted yield episode could commence around the year end and a recession could then begin in late '07 or early '08. Another piece of evidence that might suggest that the Fed is stumbling a bit right now, is the above timing. I don't believe the Fed would consciously want to engineer a recession starting in a presidential election year.

However, history does not always precisely repeat itself, so it becomes of interest to examine the details of the current situation as it compares with historical precedent. In this respect, the striking difference - the major departure from all previous money tightening cycles - is that this will be the first time ever that a listless economy has been subjected to the effects of an inverted yield curve. In every other instance, the economy has been superheated, with higher rates of inflation and higher long term interest rates. You might say that this situation is the exact opposite of the circumstances that existed in the fifties. If there is any variance in the current outlook, therefore, it would appear that the Fed's restrictive policy may have a greater than normal impact. The odds would seem to favor a recession beginning earlier, becoming deeper, and lasting longer than its predecessors, with the very real possibility of a general drop in prices, otherwise referred to as deflation.

Mr. Greenspan may really, really, really be looking forward to packing his bags and heading for the beach in January.............

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  • At Sat Sep 03, 01:51:00 PM PDT, Anonymous Johnathon Stone said…

    Very nice but Johnathon Stone would have done better

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