Greenspan: Haunted by the Conundrum

Chapter 20 of his “The Age of Turbulence” opens with Greenspan in 2004 perturbed by the fact that he had started increasing interest rates and long term rates were not budging. This was named the “conundrum” and it has haunted Greenspan ever since. His recent self defense in the WSJ (March 11) was mostly a rehash of his arguments in chapter 20 of his book adding to it a criticism to John Taylor´s accusation that the house bubble was his fault for keeping the Fed Funds rate too low for too long.

In the end, as has been fashionable for some time, at least since Bernanke came up with “The global saving glut” hypothesis, fault the Asians in general, the Chinese in particular and throw in an assortment of other developing and emerging markets.

As figures 1 & 2 show, after 1997, coinciding with the Asian crisis, there developed a large gap between savings and investment in a broad set of countries.

image001_512_11.jpg But this state of affairs did not fall out of the blue. It was the successful result of the policies and actions recommended by the IMF and by outsiders (see, for example, Martin Feldstein´s “A Self-Help Guide for Emerging Markets”, Foreign Affairs March/April 1999) following the 1997/98 crisis in Asia (which was followed in short sequence by the Russian and Brazilian crises in 1998).

On the other side of the “adjustment equation” was the US, the only major economy growing robustly at the time (Japan was in the midst of its long slump and Germany/Europe was wobbly). This state of affairs was baptized by Michael Dooley, Peter Garber and David Folkerts-Landau in 2003 as “Bretton Woods II”.  To call this an “international imbalance” sounds strange since it was the “balancing” mechanism.

If an unintended consequence of the adjustment process, that paved the way to the present crisis, was fraud (from lack of supervision) in addition to government giving the wrong incentives by encouraging homeownership to all, that´s a separate question that will have to be addressed in detail.

Krugman suggests that the crisis is “the revenge of the glut”. I prefer to ascribe it to “payment due for sins of omission, false testimonials and political greed”.

It´s a basic fact that officials (like Greenspan) prefer to put blame for “bad outcomes” on forces outside their sphere of influence. The “conundrum” (although as we will see is not a “bad” outcome) is no exception. But maybe there is a much simpler “homegrown” solution which is a direct result of Greenspan´s, among others, actions.

The “conundrum” story evolves as follows: between June 2004 and July 2006 the Fed raised rates from 1% to 5.25% by increments of 25 basis points in all 17 meetings. In his February/05 H-H testimony before Congress Greenspan used the term “conundrum” (Latin for enigma) to describe the fact that long term (including mortgage) rates had not followed suit. I stop the story in July 2007 to exclude the crisis period that began in August. Figures 3 and 4 illustrate.

image002_512_10.jpg Funny that there are few mentions to the “reverse conundrum” that took place between January 2001 and May 2002[1]. While the FF rate was brought down from 6.25% in December 2000 to 1.75% in January 2002, the long rate did not move. But just at that point inflation began to fall and the 10 year rate decreased. Bernanke´s famous “helicopter Ben” speech in November 2002 followed by the FOMC´s statement at the May 2003 meeting where it was said that “…In contrast, over the same period, the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level…” helped keep long rates at this somewhat lower level (around 4%).

On the way down and then on the way up, the FF rate did not directly affect the long rate. In fact, all the commotion around the “conundrum” is tied to the consideration that “it is a well accepted fact that the absence of change in the long rate at the same time that the FF rate changes significantly defines a break in the historical relation between those rates”.

Can we observe this “fact” in the data? A simple way to check if long rates usually move in tandem with the FF rate is to see if the ratio of the 10 year rate to the FF rate stays close to 1 at all times.

Figures 5 and 6 are illustrative of an apparent change in the relation after 1990. Between 1965 and 1990, the ratio of the 10 year rate to the FF rate never drifts for too long and keeps close to 1. This is true for the rising inflation period (1965-81) where there are large swings in rates as well as for the falling inflation period (1982-90).

However, this is not so after 1990, despite much smaller swings in rates. During 1992-94 the ratio remained persistently and significantly above 1 and even more so during 2002-04.

image003_512_06.jpg More formal (regression) analysis supports this finding. While for the whole of the 1965-90 period as well as for the shorter 1982-90 period, the slope coefficient is statistically significant and the monthly variation in the FF rate also explains a not insignificant portion of the variation in the long rate (15% to 20%), for the post 1990 period the slope coefficient is not statistically significant and the variation of the FF rate explains less than 1% of the monthly variation in the long rate!

It appears that if we can find the reason for this marked change in the behavior of rates we will have “solved” the “conundrum”. Below I put figure 7 – showing the long rate, FF and the ratio between the long rate and FF for 1956-64 – side by side with figure 6 already shown above. Contrary to what was observed for 1965-90, the TB 10yr/FF ratio also shows persistent and significant departures from 1, much like for the 1991-07 period.

image004_512_05.jpg What does the 1956-64 period have in common with the post 1990 period? Both are characterized by low (falling) inflation and, importantly, the absence of expectations of rising inflation. In other words, in both periods the monetary authority possesses credibility. Fifty years ago inflation was not something that “kept people awake at night”. Only 25 years before the Great Depression had brought deflation to the fore. More recently, credibility was obtained with great effort and after many years of hard work.

One evidence that supports this solution to Greenspan´s “conundrum”, i.e. that it is associated with an environment in which the credibility of the Fed is strong, is given by the construction of what we could call “Inflation credibility in the bond market”.

This construction is borrowed from William Dewald[1]. Based on observing real output growth, the behavior of the long rate[2] and inflation over the last 54 years, we can conclude that inflation expectations were the dominant influence over long term interest rates (for example, since long rates went up when inflation accelerated at the same time that output growth was reduced, we deduce that inflation had a much greater influence on long term interest rates).

To capture the inflation risk premium embedded in expectations (or projections) of long run inflation (which Dewald calls “inflation credibility”), we  calculate  the difference between the 5 year average of the 5 year Bond and the 10 average of real GDP growth. (This analysis rests on the assumption that real rate of interest can be approximated by the rate of growth of real GDP, when both series are averaged over a moderately long period of time).

In figure 8, this measure is reflected in the height of the shaded area. The other lines show the 10yr average growth rate, the 5yr average of the 5yr bond and the 5 year average of the inflation rate.

image005_03.jpg Since the beginning of the 1990´s, with inflation relatively low and stable, the Bond market gradually came around to the idea that inflation will remain low and stable. The “inflation risk premium” implicit in the long rate converged, although not to zero as in the 50´s and early 60´s, to quite a low level. In 2007-08 there´s an uptick, most likely associated with the wrong inflation call following the rise in oil and commodities and the fall in the dollar. But this is not what we are interested in since the “conundrum” predates the “uptick”.

But Greenspan didn´t see or if he did, did not believe in this very compelling evidence for “solving” the “conundrum” because at the very end of the “Conundrum” chapter in his book he writes: “Central bankers over the past several decades have absorbed an important principle: Price stability is the path to maximum sustainable economic growth. Many economists in fact credit central bank monetary policy as the key factor in the last decade´s reduction in inflation worldwide. I would like to believe that. I do not deny that we adjusted policy to be consonant with global disinflationary policy as they emerged. But I very much doubt that either policy actions or central bank anti-inflationary credibility played the leading role in the fall of long term interest rates. That decline (and the conundrum) can be accounted for by forces other than monetary policy…” Go figure that!



[1] A notable exception is David Altig: See D. Altig and Ed Nosal: “Why Haven´t Long Term Interest Rates Fallen”. Federal Reserve Bank of Cleveland Economic Commentary January 1, 2002.
[2] See William G. Dewald: Historical U.S. Money Growth, Inflation and Inflation Credibility, Federal Reserve Bank of St Louis Review November/December 1998.

[3] Here we use the 5 year bond rate as representative of long rates so as to be able to work with the largest possible number of observations.

One Response to "Greenspan: Haunted by the Conundrum"

  1. NFrazier   March 17, 2009 at 2:19 am

    This is quite puzzling. I suspect that the credibility of the Fed to fight inflation does improve after major periods of expansion of productive capacity though – to the point that the productivity of that capacity becomes marginal as reflected in real costs of capital that approach zero… At such times, raising the FF risks exposing the economy to greater deflationary forces and this would eventually show up as a flattening of the yield curve.Complicating the analysis, however, are whether the bond market expects such excess capacity to be fought with monetization of debt (at some point) or spending down of fiscal credit to an increasingly risky degree. (The former may explain why the 30yr end didn’t follow the FF down in 1998.)There are also various bubbles that were growing or bursting at various times, their effects on inflation and the yield curve, international capital flows, etc, etc.