In 2002–3 short-term interest rates were cut to 1 percent in the US, 2 percent in the Eurozone, 3.5 percent in the UK, and 4.25 percent in Australia. In Japan they stayed at zero, where they had been since 2001.
Yet over the long run, a neutral rate of interest would normally be expected to be 2–3 percent above inflation, or around 4–5 percent if central banks are hitting their inflation target of around 2 percent. Of course, with economies weak and inflation below target, low rates made perfect sense. And the strength of world economic growth in 2003–4 suggests that they are having the desired effect. But these levels are unsustainable and rates are likely to increase to more normal levels at some point.
In the past, US tightening episodes have often been disruptive to asset markets. Chairman Greenspan’s first direct experience of this was with the October 1987 stock market crash; he had taken over the chairmanship in August, just weeks before. The Fed had begun to move rates up earlier in the year and bonds markets slumped in the early summer. But stocks surged upward between January and August, encouraged by the strong economy and rising profits. The sudden crash in October, which took the US market down 30 percent in two trading days, was a severe shock. The immediate worry was that a crash like this, so reminiscent of the 1929 crash, would lead to a 1930s-style depression.
Of course it did not, partly because Greenspan quickly cut rates, but also because the bubble and crash constituted a very short-lived affair.
At the end of 1987 stocks were pretty much back where they started the
year. Still, this was Greenspan’s first experience of the difficulties of managing monetary tightening, especially in the presence of a bubble.
Once it became apparent that the 1987 market crash had had little impact outside Wall Street and the economy was still strong, a new tightening program began. Rates peaked in early 1989, at which point the economy began to slow. But, despite steady reductions in rates later in 1989 and 1990, the economy slid into recession in late 1990.
Part of the reason was Saddam Hussein’s invasion of Kuwait, which sent oil prices sharply higher. But the data imply that the economy was already heading into recession, suggesting that policy was eased too slowly.8
The next time Greenspan was hauling on the tightening levers was in 1994 and this is perhaps the closest comparison with the cur- rent environment. By 1994 a gradual, “jobless” recovery was giving way to renewed economic vigor. Unemployment had started to come down rapidly and it was believed that interest rates needed to be nor- malized. Rates went down to 3 percent in the early 1990s recession, but since inflation was also about 3 percent, this is directly compa- rable to the situation 10 years later, with both interest rates and inflation at 1 percent.
The Fed began to tighten in early 1994 and took rates up 3 percent in little more than a year. Again, bonds crashed, with yields jumping by a similar amount. However, the stock market dipped only a touch and then marched sideways, ending the tightening period close to where it began. Other countries’ markets performed in a similar way, except those in continental Europe, which did somewhat better as it emerged from recession.
The best hope is that we will see a similar outcome this time. Bond yields dipped to 3.1 percent in mid-2003 and spent much of the fol- lowing year in the 3.5–4.5 percent range. But if short-term rates are ris- ing in the direction of 3–4 percent or so, 10-year bond yields could head toward the 5–6 percent range. It would seem difficult for stocks to make a great deal of progress in this environment, though if the econ- omy is strong profits will be rising, providing some support.
This brings us to the final legacy of the stock bubble, perhaps the most important of all. In pulling out all the stops to escape the
aftermath of the stock market crash, the danger is that a new bubble has been created, in housing. Buoyancy in house prices has been key to Greenspan’s strategy for escaping the full implications of the stock bust.
And for some people property has taken the place of stocks and pen- sions as a vehicle for funding retirement. However, valuations in hous- ing are now high in the US and elsewhere, in sharp contrast to 1994. It is to housing that we turn in Part II.
PART II