I don’t actually know if it was a dark and stormy night, though I like to imagine it had to have been if only to properly set the stage. The date was December 5, 1996, twenty-five years ago last week, and the physical setting apart from the weather conditions certainly wouldn’t have indicated imminent drama. Thus, my importing perhaps imaginary atmospheric turbulence.
This was the dinner celebration for the American Enterprise Institute’s Francis Boyer award. The prize had been established long before, back in 1977, by pharmaceutical firm SmithKline Beecham in memory of its former chief executive. Prestigious enough, its first recipient all the way back in ’77 had been President Gerald Ford.
Nineteen prize winners later it was Alan Greenspan’s turn. The Chairman of the Federal Reserve throughout that roaring decade was just coming into his own, reaching the absolute peak of his reputational luster. The bureaucracy he led had been entirely transformed, much if not most on his watch.
Rolling out interest rate targeting and rethinking the way and manner of the “central bank’s” relationship with inflation, what the Fed had been doing was very different from how it’s said. To this day, all the textbooks still cite its monetary policies as, well, monetary.
Greenspan knew better. From years before his time atop the nation’s nominal pecuniary institution, the man they’d call “maestro” had seen the world’s monetary system rewritten; and not by some cabal in position of authority executing a master strategy of optimal outcomes. This had all been done on a whim; a series of complicated, interlocking, and entirely private whims dating back to the middle 20th century.
The banking system first connected globally by the emerging telecommunications revolution and then revolutionized the way in which monetary agency was conducted from the ground up; from the inside out (thus, interbank relationships). Long before Volcker let alone Greenspan, money had become a thing for banks thereby putting central banks out of the money business.
This was, actually, the thrust of Mr. Greenspan’s recipient address that cold and stormy night back in ’96. But it was not the message the public would take from his acceptance speech, even though he delivered his remarks with unusual candor and straightforward language (nothing like the fedspeak he’d later become infamous for).
Whether the weather had been bad wouldn’t really matter, of course. The two little words everyone heard and focused entirely upon thereafter had set off a gale of controversy the world over, totally overwhelming his message. The eminently respected Federal Reserve Chairman had said “irrational exuberance” and thus was born the dot-com bubble (as it relates to public perception, anyway).
His phrase, however, wasn’t necessarily directed at the public’s newfound infatuation with the NASDAQ. Maybe stocks were becoming quite bubbly, but, Greenspan wondered, how would anyone truly know?
The real problem he was trying to explain was much more basic and fundamental, applicable to the world way beyond the racing canyons of Wall Street. This was real economy stuff, the very stuff the world had thought it would come to depend most upon best left to the monetary geniuses at the Fed.
Alan Greenspan instead cautioned the world and everyone in it that, no, when it comes to money those working at the Federal Reserve had been just as much in the dark, having been left blacked out for quite a long time. For years already, decades, policymakers really had been making things up as they went. In the “maestro’s” own reluctant words:
“At different times in our history a varying set of simple indicators seemed successfully to summarize the state of monetary policy and its relationship to the economy. Thus, during the decades of the 1970s and 1980s, trends in money supply, first M1, then M2, were useful guides. We could convey the thrust of our policy with money supply targets, though we felt free to deviate from those targets for good reason…Unfortunately, money supply trends veered off path several years ago as a useful summary of the overall economy. Thus, to keep the Congress informed on what we are doing, we have been required to explain the full complexity of the substance of our deliberations, and how we see economic relationships and evolving trends.”
Therefore, how would anyone rationally assess whether or not asset markets were behaving irrationally? You could make this a defense of stock prices as well as a word of caution directed back at them. Yet, the man’s point was really how this wasn’t about stocks at all. Far broader, the implications were, and truly would be, all over Main Street (see: 2007-21).
Without it, absent currency overflow, there can be no inflation; complete economic function itself can only struggle. The same cannot be said of consumer prices, especially in the short run. These, on the other hand, can be highly influenced by any number of non-monetary factors. Politics, sure. Mostly, however, basic economics.
But basic economics also mean limitations. If a severe disturbance should develop in one narrow economic segment, causing prices related to and within that segment to rise even precipitously, though a CPI will calculate these rising prices for what they are the public will interpret this change as inflation when it is not.
On the contrary, again absent the money small “e” economics demands an adjustment. With an over-contamination of currency, consumer prices can proliferate one after another as nominal conditions are flushed with the monetary resources to keep up one set of prices following along all the rest.
It was Mr. Greenspan who probably knew best about this adjustment process, too. Back around the start of the decade, six years and four months prior to our headline storm, Saddam Hussein had unleashed a very different one on Kuwait, pushed the US economy into recession, and the Federal Reserve to the forefront of imagination.
Triggered by this belligerence in the oil-soaked Middle East, if you don’t remember or aren’t old enough to have lived through it, you still have no trouble imagining the market’s priced response to Iraqi tanks parading through Kuwait City. Provoked by fears of supply disruption, very real worries given Hussein’s score-settling personality and megalomania, WTI understandably skyrocketed.
The US benchmark (spot) price had hovered around $20 a barrel for much of 1990; getting as high as $23 while as low as under $17. By August 1, the day before, WTI’s front futures price stood at $21.54, and that was up ~$4 from just a few weeks before (markets tipped by the buildup of troops).
From August 2, the day the Iraqi forces moved forward, until October 11, 1990, the price of (spot) oil in the United States more than doubled. From its low of $16.47 on July 6 to a high of $40.40, the highest in nearly a decade in a very short space of time (this sounds really familiar).
Various inflation indices would catch the crude shock; the CPI, hanging around 4% as had become standard for the late eighties, would quickly accelerate to 6.3% that same October. The PCE Deflator, which, in 2000, the Federal Reserve would publicly admit the institution preferred, even here the annual rate of change would hasten from 3.9% in June 1990 to 5.2% as crude oil prices topped out just a few months later.
While many at the time feared the Great Inflation was being reignited all over again, the opposite would turn out.
In fact, the NBER, the orthodox Economics association self-appointed to decide the business cycles and date them, they said the US economy had fallen into recession by July 1990 just as oil was beginning to bite – a whole month before the Iraq attack.
And Alan Greenspan had noticed something peculiar in the monetary system, too, concurrent to all these geopolitical upsets. He would later tell Congress in 1993, as well as refer to this episode in his 1996 speech, something wonky had taken grip in M2 (though he was cavalier in his recounting, M1 had been officially disregarded too late in the seventies). Velocity seemed to skyrocket if out of nowhere – which simply meant, as he stated to both the legislature and his later Francis Boyer audience, M2 had finally proved itself entirely unreliable.
Thus, the entire CPI focus in the second half of 1990 was itself irrationally exuberant by the indirect product of Saddam Hussein’s ill-fated human disaster fear-priced into black gold. Without a useful M2 or alternative available, how would anyone tell otherwise?
Yet, there was no overrun of money. On the contrary, the resulting oil shock far from reestablishing runaway inflation had contributed much – maybe most – to the nascent recession; following which, consumer price indices all decelerated sharply (and then never recovered; as I wrote about a few weeks back discussing “inflation expectations”).
In fact, the US economy had been substantially weakened even before 1990 had begun. The S&L Crisis, reaching its own apex around late 1989, this had been the reason for M2’s growing deviation – depository money was falling down given that depository institutions had done many stupid things (engaging in wholesale tactics not well-suited to their businesses).
This small-scale bank crisis had sapped a good bit of economic vitality in the retreat of credit across the entire economic landscape, while simultaneously diminishing the availability of traditional types of money (the kind counted by M2) – thus, one key reason why Alan Greenspan could’ve been so highly confident the WTI surge of mid-90 wouldn’t spiral any further on the inflation side.
Deflation potential had, to some legitimate extent, preoccupied the minds of policymakers before, during, and after what became known as the Gulf War. Having entered in bad shape to start with, oil prices were at least one too many negatives for the economic system to handle (and if the shock didn’t provoke the recession, it surely contributed much to its initial severity and the misery experienced by those going through it; what may have seemed like a throwback to the mid-70s).
With this in mind, we move forward from the drama unfolding around the Persian Gulf in 1990 and 1991 beyond 1996’s missed opportunity to comprehend what really had gone irrational to now near today something which may seem very much like it. On October 21, 2021, 5-year TIPS demand. Ironically enough, the inflation “expectations” these inflation-protected Treasury instruments display had set off quite rational alarm bells ringing that, on corroboration and further thought, perhaps too reminiscent of 1990.
The 5-year breakeven rate (that is, the difference between the nominal “real” TIPS yield and the same maturity nominal US Treasury yield) had been 277 bps on October 20; much higher than it had been since 2011. After the auction for this same instrument had concluded, the breakeven rate surged by an enormous 27 bps!
This was unusual, to say the least, in its ferocity. The market, in this very narrow context, seemed to be saying that, yes, inflation – real inflation - was truly getting out of control so much that it had caused a major upset at this incredibly important TIPS benchmark.
Beyond October 21, over the next four weeks the 5-year breakeven rate would continue to rise all the way to 317 bps! The reason for this, quite simply, an entirely rational response to rising oil prices that have been rising because supplies of crude oil haven’t come close to matching the world’s rebound in demand.
An oil supply shock.
Since the inflation protection part of TIPS are paid off by the government in the form of the CPI, and the CPI is basically a marginal product of oil prices, oil becomes gasoline which then registers in the CPI and traders in TIPS trade to inflation breakevens.
However, this inflation certainty wasn’t copied anywhere else on the TIPS “curve.” On the contrary, this action at the 5-year TIPS term greatly amplified the inflation-protected market’s longer-run defenses. The 10-year breakeven rate only gained 7 bps on October 21 (compared to the 5s twenty-seven) and these would top out no higher than 264 bps.
The inflation “expectations” were upside down, inverted as to how they would be if this was actual, long running monetary inflation (thanks to Emil Kalinowski, I hate that term even more).
That’s not all; this is just where it began. Global bond curves, including what’s now an inverted eurodollar futures curve, these all began to twist and distort in a provocatively deflationary display, all of them dating back to right around October 21 (including Bitcoin!) when afterward curves have uniformly flattened and nominal rates longer-term have sunk.
Despite the Fed’s taper (announced November 3) and double taper (announced on Wednesday), and the US CPI reaching its highest level since before anyone knew Alan Greenspan’s name, US Treasury yields after the belly of the curve are all lower and increasingly deflation-arily twisted.
What does all this mean?
The upside-down TIPS breakevens along with the flattening curves globally are dependable signals that consumer prices are not going to continue to accelerate; or even very likely to continue at these levels for very long. On the contrary, the markets are more and more pricing something like the early 1990’s where especially the supply shock in oil more likely contributes to their eventual downside.
Questionable more likely deflationary money to go along with that clear oil price shock, neither of those would be conducive to the economic climate by which consumer prices outside or inside of gasoline continue as they are now. Curves and markets are increasingly saying something is going wrong, and with the dates coincident to that 5-year TIPS auction it’s hard to avoid making these specific retro comparisons.
This doesn’t mean the die has been cast, the future now set in stone. Without being able to directly define and locate monetary conditions, we’re left with probabilities, though a spectrum of possibilities which are leaning more and more heavily in this other direction.
Despite all this, all anyone today says is how (and they all claim to be certain about this; have you seen M2?!) excessive money has been the cause of massive inflation embedded in the CPI at its highest in almost forty years.
Alan Greenspan stood before an esteemed gathering a quarter century past and warned those in it not to be complacent about what the textbooks all say when it comes to money. What he said was, given their self-imposed limitations, something that should be very simple, money’s relationship to inflation of any kind or intensity, actually is unbelievably complex and uncertain (at least by his own viewpoint; the rest of us have no need to impose such blindness).
On final reflection, I guess the weather conditions really didn't matter. Borrowing upon experience earlier in the decade as well as being at least attuned to this massive fundamental blind spot, we would do well to heed Greenspan’s words. Just not those particular two anyone still remembers.