Greenspan leaves where Volcker did in the middle of a rate raising campaign, hoping to land an economy rather than crash it. The odds against him are getting longer, according to the yield curve, this is the last rate increase before "inversion". What has lead to some increasingly audible jitters is the consensus that there is at least one more coming.
The spot bond market has a flat curve, with a bit of wiggle at the end.
The Treasury's yield curve shows the six month having no more room for another hike.
Unless the markets bail him out, Cousin Ben is going to find out whether the markets like him as much as they loved old Uncle Alan.
He's going to need it, the real spread on the bond rates is now flat, which means that bond buyers have a chance, but they don't have to take it.
So what is it with the "yield curve"? And why is Alan called "The Maestro"? It's simple, Alan Greenspan was the most adept tactician of open market operations of any central banker in modern history - when he set a rate, that is the rate that actually happened. You see, the fed doesn't turn a knob, it has to intervene in the market. Greenspan's mystique was 50% that he was good at doing what he said he was going to do, and made "Don't Fight The Fed" an investors mantra.
So what about "the yield curve"?
Well you are going to read a great deal of mumbo jumbo about omniscient bond traders always knowing when the bottom is going to fall out of the market. But it bond traders were so smart, they wouldn't be trading bonds - stocks have higher yields over time. Instead, what is going on is this - the Fed controls the short end of the yield curve only, the treasury as some influence over the shape of the yield curve, and the economy controls the long end of the yield curve.
The long end isn't really investment, it is money in drag. Let me explain. Let's say you have to finance something - like say, a currency. The Yuan will do nicely. You don't want people dumping the Yuan, and you don't want them gobbling it up either. You, the currency printer, want the benefits of the currency. The way to do this is to extract profits from the economy that the currency runs, and pile it up as dollars. That way if traders dump your currency, you snarf it up, and when it recovers sell it. If traders start snarfing up your currency, you put those dollars into banks in your country, and that creates more of your currency, and the price falls.
The key to this is holding dollars. Only, dollars have a problem - inflation eats away at them over time. So you hold bonds. Long bonds. Why long and not rolling over the short term stuff? Because the money really isn't going any place, why pay a bigger penalty for it than you need to.
The other group of people who love long bonds are people with big projects that they want to put up collateral for. Why have the value of it erode?
This means that as long as the big movers of the world economy - say countries that pump oil, countries that export lots of goods, and big builders of commercial and industrial capital - push long rates down if they are being active.
Now, if the fed raises short term rates, and this slows down the economy, then the big boys feel it - oil prices drop, commercial projects are pulled, and people buy fewer television screens and cars, so less need for factories. This means that the rates at the top go up, as there is less collateral money parked in long bonds. Remember - interest rates and bond prices move in opposite directions. The more money that wants in to the bond market, the lower rates are. The economy slows - which is what the fed wants, and there is no recession.
However if the Fed raises rates, and people keep buying SUVs with LCD DVD screens in them to go to their TSPs after flying LUV - sorry, couldn't help it - then Ford, Sanyo, Sony, Toll Brothers, Boeing and Southwest - along with the governments of OPEC and the PRC - have money to park as they build factors and pile up reserves. This means
that the long rates go lower than the short rates - that is, the yield curve "inverts" because normally there is a lower interest rate on a shorter loan. You can see this from mortgages - a 15 year has a lower rate than a 30 year.
So the yield curve inverts before a recession, not because bond traders are omniscient, but because low long term rates are the result of profits and continued investment - which is causing inflation - and the fed has to keep raising interest rates until they go away. This is why in the last three recessions, long rates have gone up after the recession has started, and this was the signal to the fed that it could start cutting interest rates again.
So what does all this mean?
Well the yield curve inverting is so well known a signal that the fear at the fed was that it would be self-fulfilling - if they allowed the yield curve to invert, then everyone would pull back, because of that great conservative mantra "a loss of business confidence". Now, no one has ever observed a recession caused by a loss of business confidence, but none the less, no one at the Fed wanted to test the assertion that one can have an inverted yield curve without a recession. It has happened. Once. Under LBJ. The recession came anyway.
So there were two decisions. One was by the treasury not to sell long bonds - that way, people had to pile into shorter bonds, and the yield curve would have a hard time inverting, because the long bonds were going to have artificially high interest rates. Cute, but almost certainly not effective. It isn't the altimeter that causes the plane to crash.
The second decision was to raise interest rates at a monumentally slow pace. Warn people way in advance, and give them plenty of time to get out of the way. However, the result was energy inflation. In short, it didn't slow the economy down.
The saving graces were two fold. One was that it is a lousy economy. It runs OK for a fat guy, I suppose, but getting this economy to overheat is hard. The other saving grace was that other world economies were in even worse shape than the US was - so inflationary pressure didn't rise as fast as it could have. That's what they get for bailing Bush out, like complete idiots.
Katrina helped by giving us a quarter of slow growth which helped hold most inflation at bay. But when rebuilding kicks in, so too will that inflation.
Now the right wing will tell you that "core inflation" is low, and therefore energy inflation isn't a problem. This is exactly wrong - in the time since the Bureau of Labor Statistics has tracked it, high inflation against CPI is a good indicator of a coming recession.
This is because of the same reason as the yield curve - energy is what people sell us, other stuff is what we sell them. If energy is going up faster than the prices of manufactured goods, it means we are getting less and less for what we sell, and burning more and more oil and energy to get it. That's called O V E R H E A T I N G.
This means that the signs are that we are about to hit the crisis point, where good decisions have to be made. Yeah, right. We are, instead, getting "Health Savings Accounts". I can't talk about HSAs, because if I did, I'd be fired. That's really all I can say about them.
The other pressure is that the petrodollar holders aren't going to ship as much of their oil gotten gains here. Instead they are starting to build internal economies. Since the rules of Free Trade don't apply to countries the west really needs things from, they are going to do what China has done - engage in pervasive protectionism, trade what they have for the key capital they need to dispense with the US, and put less and less in dollars.
The generation long ride - where we buy oil from them, and they loan the money back to us to pay for our big military to protect them - is coming to an end. The ultimate failure of Iraq is that it degraded America's most important export - security.
Which means that the era of feeding our rich to stay ahead of their rich is about to come to a halt. Likely after the next recession teaches Americans what a good round of bone crunching deflation does to borrowers.
So here we are, Greenspan rides off at the right moment, and Ben comes in at the wrong moment. There may not be a recession this year, we still have chances for investors to move to equities rather than buying commodity inflation, but they had better do it fast. And the Federal Government needs to slash expenditures to get rid of the inflationary pressure that reconstruction is going to generate.
This economy is near full employment, for it. Not full employment mind you, but as good as this economy gets. The output gap is razor thin - that is, we are using almost all of our capacity. Unemployment is very low - which means that wage pressures are cropping up for the kind of employees we need. The problem is that the expansion was a quarter inch wide and a mile deep into the housing sector. We are getting inflation in health care, because there are lots and lots of other people in the US that we can't find jobs for - and so they aren't "unemployed" they are "out of the labor force". That's econo-speak for "screwed".
Summary - the economy is very close to recession, and might fall into it at any time. Disasters actually help Bush, because they slow the economy down artificially, without monetary policy. We aren't in recession, because the Gulf Coast is experiencing a colour remake of the Great Depression.
Poor decision making has lead us to the point where the economy is fragile, and there are huge profits that have nothing to do. These huge profits are piled up in bonds and commodities, and not in making America better.
The oilarchs and others who have financed our borrowing binge have noticed, and are moving money away from us. This means that we are going to have a generation long head wind, as we go through withdrawal from all that cheap money - about 2000 dollars - per person. That's 8000 dollars for a family of four. Per year. You aren't making that up by cutting back on cigarettes.
Recession isn't certain, we haven't gotten all the way there. But people would be foolish not to make sure they can handle a sharp down turn in employment starting next January.