Tuesday, March 13, 2007

. Alan Greenspan. "Technological innovation and the economy", remarks before the White House Conference on the New Economy, Washington, D.C. April 5, 2000

While foreign central banks continue to act as the key providers of global dollar liquidity, the "domestic" scene is dominated by the restrictive stance of the Federal Reserve. The stock of Treasury securities held by the Fed ―the main counterpart to the monetary base on the asset side― is growing at 2.25%, the lowest rate since ... January 2001. The shape of the yield curve is the key "tell" here ― as the Maestro himself told us in an April 2000 speech. There is no way to avoid a lenghty quote:

As our experience over the past century and more attests, such surges in prospective investment profitability carry with them consequences for interest rates, which ultimately are part of the process that balances saving and investment in a noninflationary economy. In these circumstances, rising credit demand is almost always reflected in an increase in corporate borrowing costs and that has, indeed, been our recent experience, especially in longer-dated debt issues. Real interest rates on corporate bonds have risen more than a percentage point in the past couple of years. Home mortgage rates have risen comparably. The Federal Reserve has responded in a similar manner, by gradually raising the federal funds rate over the past year. Certainly, to have done otherwise--to have held the federal funds rate at last year's level even as credit demands and market interest rates rose--would have required an inappropriately inflationary expansion of liquidity. It is difficult to imagine product price levels remaining tame over the longer haul had there been such an expansion of liquidity. In the event, of course, inflation has remained largely contained.

Back then, Greenspan was referring to a normal yield curve, with long-term yields solidly above the Fed funds target. But the same reasoning applies to today's situation ― with the opposite conclusions. To the extent that it reflects a decreasing demand for bank reserves, an inverted yield curve must lead to one of the following scenarios: (a) the Fed validates the new equilibrium (and lower) target; (b) the Fed destroys bank reserves (by selling bonds in the open market) to keep its current target intact. In that case, the mechanics of an inverted yield lead to an automatic contraction of (domestic) liquidity.

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