Greenspan Legacy: A Dragon Throttled

Times Staff Writer

Was your inflation rate 2% last year?

Tallying up your gasoline and grocery bills, you may feel like 2% is a low-ball figure for inflation.

But that number seems legitimate to much of Wall Street because it is the inflation rate as measured by the preferred price gauge of Federal Reserve Chairman Alan Greenspan.

As the central bank chief prepares to step down this week after 18 years at the helm, his legacy is that he subdued the inflation dragon once and for all.

Indeed, he has convinced many big investors that there is virtually no chance of the dragon reviving.

That, some say, best explains the so-called conundrum: why long-term interest rates have remained so low even as the Fed has methodically raised short-term rates since mid-2004.


By this view of the world, the current 4.5% annualized yield on a 10-year U.S. Treasury note is a great return, one you should be happy to lock in, because there’s little risk of rising inflation that would eat away at it.

If that’s true, 30-year mortgage rates may be stuck around 6% for a long time to come. They might even fall toward 5% in the next few years, which could bail out tens of thousands of people who bought homes with adjustable-rate loans that are ticking time bombs.

As for the stock market, it could be thrilled if long-term interest rates stay where they are or edge lower. It already seems thrilled enough: The broadest measure of share prices on the New York Stock Exchange hit a record high Friday.

There are other possible scenarios for inflation and long-term rates, however. One is that they’re poised to accelerate, not to the legendary levels of the 1970s but high enough to make fools out of many investors and economists, and to soil Greenspan’s image -- not to mention leaving a mess for his successor, Ben S. Bernanke, who will take over the Fed chairmanship Wednesday.

When Greenspan succeeded Paul Volcker in 1987, memories of the double-digit inflation of the late 1970s still were fresh. Financial markets, which were crippled by rising inflation in the ‘70s, lived in mortal fear of another go-round.

Here’s how Greenspan naturally would prefer the history books to read: It was his willingness to tighten credit by raising short-term interest rates in the late 1980s, in 1994, in 1999 to 2000 and for the last 18 months that quashed potential inflation pressures by slowing the economy, even to the point of recession in 1990 and 2001.

But forces beyond the Fed’s control also have been weighing on inflation since the mid-1980s. One was the dramatic plunge in oil and other commodity prices in the 1990s.

More important have been the forces of free trade and economic globalization, which have favored low-cost producers of goods and services worldwide.

Whatever the causes, inflation is a shadow of its former self.

Greenspan’s favorite inflation gauge -- the “core” personal consumption expenditures price index -- rose 2% in 2005, the same as in 2004, according to the government’s initial assessment of fourth-quarter economic growth, reported Friday.

The trend in that index has been up since 2003, when the annual increase was a mere 1.3%. That has given the Fed justification for trying to slow the economy by raising its benchmark short-term interest rate from 1% in June 2004 to the current 4.25%. And when policymakers gather Tuesday for Greenspan’s final meeting, they are virtually certain to raise the rate again, to 4.5%.

But flash back to the early 1990s, when core inflation was pushing 4%. Or to the early ‘80s, when it was pushing 10%. The idea that 2% could be a problem would have been laughable back then.

The whole core-inflation thing, admittedly, is an irritant to many people. The core rate excludes food and energy costs, which economists generally believe are too volatile to include if you’re trying to gauge the long-term trend in inflation.

Yet your personal inflation rate does indeed include food and energy costs. And because of soaring oil prices, the consumer price index for all goods and services was up 3.4% last year, the largest calendar-year increase since 2000.

Someone who drives a truck for a living probably would enjoy arm-wrestling a government statistician who contends that the inflation rate is 2%.

The wild gains in home prices in recent years, spurred in part by the Fed’s easy-money policy of 2001-04, also constitute a form of inflation. That’s an inflation you enjoy if you’re a seller but not if you’re a buyer.

When it comes to long-term interest rates, however, the average consumer’s assessment of inflation is much less important than what institutional investors worldwide think. They determine bond yields, and the rates they will demand will depend in large part on what they believe inflation will be down the road.

And that is the Greenspan Fed’s great victory, according to Bill Dudley, a veteran economist at brokerage Goldman, Sachs & Co. in New York.

Global investors, he says, have come to trust that U.S. inflation will stay anchored around current core levels for the long run. Therefore, they are willing to accept a 10-year Treasury note yield of 4.5% because they believe that that will provide them with a decent real, or after-inflation, return over time.

If the annualized core rate of inflation averages 2% over the next 10 years, a 4.5% bond yield would mean a real return of 2.5% a year. That may not seem like a lot, but the average real return on government bonds since 1926 has been 2.3%.

In Dudley’s view, investors are reacting logically to what he calls “the collapse of inflation volatility.” That explains, he says, why enough investors are willing to accept 4.5% on a 10-year T-note when they now can earn a slightly higher yield -- 4.55% as of Friday -- on a six-month T-bill.

Short-term rates are up because the Fed is pushing them, but they won’t be up forever, or so the thinking goes. So a stable real long-term yield trumps an equal but unstable real short-term yield, Dudley says.

This idea also resonates with Lacy Hunt, an economist and bond portfolio manager at Hoisington Investment Management in Austin, Texas.

He expects that the rise in short-term interest rates since 2004 will slow the economy this year. Combine that with the intense business competition fostered by globalization, Hunt says, and he believes the only sensible conclusion is that inflation and long-term interest rates will resume the downtrend they’ve been in since the 1980s.

The backdrop is one that “bond investors understand is disinflationary,” Hunt says. That makes long-term yields attractive at current levels, he says.

There are, of course, plenty of people on Wall Street who disagree. They see the scene set for higher inflation and long-term yields in the near term, given how oil prices are holding near $70 a barrel, how U.S. wage pressures are rising (by some measures, at least) and how the Japanese and German economies appear poised to rebound.

Joseph LaVorgna, an economist at Deutsche Bank Securities in New York, admits to having been “dead wrong” in expecting higher bond yields over the last two years.

But the risks still are greatly weighted in that direction, he contends. Investors, in his view, would be better off waiting for richer bond yields.

On the 10-year Treasury note, “I am more likely to bet on seeing 6% than on seeing 3% to 4%,” LaVorgna says.

And that isn’t even allowing for the nightmare scenarios, he says. For example, what would happen to Treasury bond yields if Chinese and other foreign investors suddenly lost their robust appetite for U.S. securities?

What if inflation pressures already in the pipeline force new Fed Chairman Bernanke to raise short-term rates well above 5%, as some economists believe is likely? Would global investors really be willing to accept 4.5% on a 10-year T-note at that point?

Gregory Hess, a professor of economics at Claremont McKenna College and a longtime Fed watcher, gives the Greenspan Fed credit for fighting inflation and -- just as important, he says -- for “engineering a regime of low inflation expectations” over the last 18 years.

With inflation, perception can be reality: If you don’t believe inflation will be a problem, you’re less likely to run your life or your business in a way that could make rising prices a self-fulfilling prophecy.

The biggest question now facing the Fed, and perhaps Wall Street, is whether inflation expectations will remain subdued or whether that mind-set will depart with Greenspan.


Tom Petruno can be reached at For recent columns on the Web, visit