If you’re bearish, the Fed seems intent on making the same mistake it has done for the past 20 years…going too far in one direction or the other. In its policy statement, the Fed gave no indication that it plans to stop raising rates. As Alchemy puts so succinctly numerous times, the Fed won’t stop until it blows something up.
What Alchemy is talking about is that when the Fed raises interest rates, trouble follows. "In 1987, the stock market crashed. In 1994, Orange County went bankrupt and Mexico devalued its peso, ravaging its economy. In 2000, the Nasdaq Stock Market bubble burst. And weak links are everywhere – from the current deficit, which could spur a sharp drop in the dollar and subsequent rise in gold and spike in interest rates – to bubble-like housing prices in parts of the United States," according to the WSJ.
Earlier in the year, the ISI Group opinied a similar idea. “It seems likely" that the Fed is about to create another crisis. "If a company or country is a weak link, that combination of higher interest rates and reduced economic activity just tips them over," says ISI economist Nancy Lazar.
Greenspan is almost always either wrong about the economy or behind the curve. In 2000, he claimed he was going to create a "soft landing" in the economy. Instead he raised rates into an economy that was already slowing, creating a recession and a stock market collapse. He then feared that we were about to enter a deflationary spiral and brought rates to an artificially low level for an extended period of time, forming the beginning of a real estate bubble.
Paul Kasriel believes that Greenspan has a “blind spot” when it comes to interpreting the yield curve. Even back in 1988, Greenspan was out of touch with leading indicators of the economy…
Back in 1988, the 10-year Treasury – fed funds rate spread narrowed from 125 basis points in August to 35 basis points in December. I remember that someone asked Greenspan whether this was a sign that economic growth would be weakening. He responded that the narrowing spread did not presage slower economic growth and continued to raise the fed funds rate, pushing the funds rate above the 10-year yield in 1989. In 1990, we experienced a recession. Between January and March of 2000, this yield spread narrowed from 121 basis points to minus 3 basis points in April. The Fed then raised the funds rate another 50 basis points in May of 2000, inverting the yield curve even more. The economy slipped into a recession in 2001.
Historically, a flat or inverted yield curve has lead to a recession according to Steve Sjuggerud at Investment U.
Chart Courtesy Investment U
In his last public appearance, Greenspan indicated that he was not done raising rates…
In his prepared comments to the Joint Economic Committee (JEC), Greenspan cut and pasted from the May 3rd FOMC policy announcement in that the FOMC still “believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability." So, the Fed will keep raising the funds rate by 25 basis points per meeting for the foreseeable future. But how far into the future is foreseeable? That is, does Greenspan know the level of the funds rate that would be “neutral”? No. Greenspan said that the Fed did not have the expertise to determine ahead of time what the level of the neutral funds rate is. But he would know it when it got there. So, the neutral funds rate might be 3.25% or 5.25%. All we could infer from Greenspan’s comments is that he believes the current 3.00% funds rate is below neutral.
Chart 2, which I repeat from yesterday’s commentary, shows the regular negative relationship between this yield spread and the ISM Manufacturing New Orders index. As the spread has narrowed in the past year, the New Orders index has plunged toward the 50 level. But Greenspan says it is different this time, just as he said back in 1988 and 2000.
So what is the Fed’s magic sign that monetary policy is neutral? How does the Chairman know when "he’s there"? Probably not when bond Guru Bill Gross says CUT! It’s probably when Greenspan blows something up.