With consumer confidence falling, predictions of a rise in inflation and government spending increasing, greenspan has a tough job
Long-term interest rates snubbed their nose at the decline in the dollar from 2002 through to 2004. They ignored the rise in the fiscal budget deficit, which hit a record $413bn last year. They even defied the Federal Reserve, which has raised overnight rates over the past 15 months from 1% to 3.75% last month.
Now, with the US government embarked on an overt spending spree, whatever it takes, to rebuild New Orleans and coastal areas devastated by Hurricane Katrina (not to be confused with the covert spending spree of the last five years), is fiscal policy about to upend the bond market?
"Market participants may well associate bad news on the economy with an increase in fiscal spending and lower bond prices," said Neal Soss, chief economist at Credit Suisse First Boston.
They may, they may not. Explaining day-to-day gyrations in the Treasury market assumes a degree of logic to the process that may not exist. A recent sell-off following the announcement of a plunge in consumer sentiment, counterintuitive as the reaction may seem, lends support to Soss's hypothesis.
As it was explained to me, the 12.2 point dive in the University of Michigan's mid-month sentiment index to a 13-year low of 76.9 means slower economic growth, which means the Fed cannot raise rates as much as it should to counter inflation. Slower economic growth means increased federal spending, which, in conjunction with the already approved $62bn for the hurricane relief effort (less than half the estimated need) augurs even higher inflation.
Bonds were also hurt, I was told, by the jump in the Michigan survey's measure of inflation expectations. The outlook for inflation over the next year rose to 4.6% from 3.1% in August, according to subscribers to the survey. Five-year inflation expectations moved up to 3.1% from 2.8%.
Unlike government statisticians, consumers' experience of inflation is the price they pay at the cash register. No quality or seasonal adjustment.
When one of the most visible costs in the family budget, prices at the pump, is soaring, consumers extrapolate higher inflation. It is hard to say whether Fed chief Alan Greenspan is more concerned about the plunge in consumer confidence or the rise in inflation expectations.
Of even greater concern to him is the federal government's lack of spending restraint at a time when the demands on the US Treasury are about to skyrocket due to the imminent retirement of the baby boomers.
Whether excess government spending is inflationary is always and everywhere the province of the central bank.
"The Fed has to be willing to adjust policy to prevent pressuring resources,"' said Jim Glassman, senior US economist at JPMorgan Chase & Co. "At the end of the day, the buck stops with the Fed."
During the Vietnam War, "no-one wanted to pay for it," Glassman said. "The risk is the Fed monetizes government spending."
The Fed regularly monetises the debt (buys government securities) to provide reserves to the banking system and increase the money supply. The problem arises when the Fed buys more debt than it normally would.
While Greenspan may subscribe to the theory that government spending is inflationary, he has to realize that he is the one that spins straw into gold.
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