2 1/2 Cheers for Greenspan Jude Wanniski and David Gitlitz January 5, 1998

We waited all last year for Alan Greenspan to express a concern that the economy might be slipping into deflation, but the Fed Chairman stubbornly refused to fire until he saw the whites of its eyes. As you surely heard, he did so in Chicago on Saturday, the third day of the New Year, at the annual meeting of the American Economic Association and the American Finance Association. The press accounts were mostly pitiful, especially The Wall Street Journal’s report by David Wessel, which said Greenspan “made clear that when he ponders the risks of deflation, he is thinking about the possibility of a sharp decline in asset prices.” That’s not what the speech was about at all. The most relevant sentence, which did not even appear in the WSJ, is the following comment: “For most purposes, biases of a few tenths in annual inflation rates do not matter when inflation is high. They do matter when, as now, inflation has become so low that policymakers need to consider at what point effective price stability has been reached. Indeed, some observers have begun to question whether deflation is now a possibility, and to assess the potential difficulties such a development might pose for the economy.”

Here he reminds his audience that while the Fed can target price indices when inflation rates are high, the flaws outweigh the practical benefits when rates are low. Because we know Greenspan has publicly stated his belief that the Consumer Price Index overstates the annual inflation rate by more than a percentage point, he is telling us that deflation may already be upon us. He also says it will have corrosive effects in some sectors even though high-tech gains are propping up the economy in others. The bond market had no trouble reading the speech. For the first time since May 1995, when shorter-dated issues were rallying in anticipation of imminent reversal of the Fed’s tightening posture, the yield on the two-year note -- at about 5.45% -- has dropped below the funds rate. An equally telling signal came in the interest rate futures market. The implied yields on three-month Euro-dollar futures contracts settling in March and June today have turned negative relative to the lead January contract. This is a sure signal that the market is treating Greenspan’s speech as an inflection point -- from a neutral-to-tightening bias, toward ease.     

We were not terribly surprised to see Greenspan finally pull the trigger. We noted last Monday that the bond market’s flat yield curve was already making that prediction, betting on the come that the Fed would now open the door to monetary ease. Some of the credit should go to Jack Kemp, a long-time friend of Greenspan’s, who publicly criticized the Fed chairman on the FoxNews Sunday show of December 29, having given up hope that private criticisms would do the trick. Kemp not only indicated the Fed should have spied the deflation when gold moved below $350 last spring, he also put the blame for the Asian financial crisis on Greenspan’s shoulders, which was exactly the political push Greenspan needed. In his Chicago speech, the Fed chairman never mentioned the word gold and did not discuss the continuing financial turmoil in southeast Asia. Most of the speech was undoubtedly written by a Fed technician, with Greenspan superimposing his own comments. Those are clearly meant to prepare the world for a cut in interest rates, if  not next month, at least by March. It also invites broader discussion on questions of monetary stability, which can only lead back to gold.