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has been a struggle to find an appropriate parallel to the economic
situation in the aftermath of September 11, as that day remains
unprecedented in our history. But there is a working parallel in
the Gulf War. In both cases, a dramatic incident punctuated what
we already knew: the economy was in recession.
In addition,
in both cases, Alan Greenspan was chairman of the Fed and a George
Bush was president. Here are where the similarities between the
two periods go:
1. During
the months preceding the current recession the inflation rate rose
prior to the economic slowdown (the reason for this is arguably
that Greenspan deviated from the price rule). The reason for the
prior recession was more obvious: We had oil price increases. Leading
up to Desert Storm, oil prices rose to $35 during the third quarter
from a $14 range at the end of 1988.
2. The
incipient inflation and the quick resolution of the Gulf War meant
that Greenspan began to withdraw some of the excess base money he
had printed. The central bank began aggressively raising the fed
funds rate. During the 12-month period from February 1988 to February
1989, the rate was hiked 10 times. The target rate peaked at 9.75%
from its 6.5% level in early 1988. Comparatively, beginning in May
1999 and ending in May 2000, the Fed again started increasing the
fed funds rates, this time nine times. The target rate peaked at
6.5% in May 2000, up from its 4.75% level of a year earlier.
3. Hikes
in the fed funds rate preceded each of the economic slowdowns. Thus,
if one is willing to assume that the temporal precedence is evidence
of a causal relationship, then Alan Greenspan deserves some of the
blame for the two recessions that we endured over the past 11 years.
We give him a lot of credit for bringing and keeping inflation in
the 2% range. However, we need to hold him accountable for departing
from the price rule and, thus, doing damage to the economy.
4. In
the early '90s, the U.S. economic recovery coincided with the stabilization
of the inflation rate. One can interpret this to mean that the Maestro
returned to the price rule. Hence, any increases in the fed funds
rate or T-bill yields reflected an increase in real rate of returns
and thus signaled an economic recovery. The question is, did the
markets anticipate the recovery?
The chart below
— which looks at the futures markets for T-bills at the end
of September 1990, December 1990, and March 1991 — can help
answer this question. The later date was the quarter right before
the recovery started. In the chart, we see a decline in interest
rates at the short end of the curve while the long end remains basically
unchanged. The decline in the futures' rates reflected the decline
in real rates as well as the economic slowdown.
The parallels
with the current slowdown fit this story quite well. We know that
short rates have been declining during the past few months and so
have the expected future short rates. However, looking at today's
interest rate futures (charted below), it is apparent that the short
rates are expected to begin a steady climb right after the first
quarter. This is consistent with our views that the rise in the
expected real interest rate is signaling an economic recovery.
The parallel
is now complete. There is, however, a key difference between this
recession and the previous one. In the earlier recession, George
Bush Sr. raised taxes, and Clinton followed suit. Thus, we had a
sub-par economic recovery. It was not until the Republicans regained
Congress that it became clear that the tax-hike movement would be
derailed, allowing the economy to kick into high gear.
In contrast,
we now have George Bush advocating lower tax rates. Therefore, we
should expect a stronger recovery coming out of this recession.
The question is, what happens to Congress in the next election?
If we continue the pro-growth agenda, there is no reason why we
could not get back to the virtuous cycle of strong growth in both
the real economy and the stock market.
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