Central Bankers, by Their Words and Actions, Suggest Inflation Remains a Serious Threat

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W hy can't that Greenspan keep his mouth shut? Why can't he learn to leave well enough alone?"

That observation was overheard on the Long Island Railroad last week, and probably was echoed on other commuter trains (and no doubt in a few trading rooms) in the wake of the reality check issued by the Federal Reserve chairman. And probably similar sentiments were voiced in Europe after the Bundesbank raised short-term interest rates for the first time in five years.

But the words and actions of central bankers served as a sobering reminder to the global capital markets that inflation remains a threat, even if it presently is confined, for the most part, to asset prices. And news of an outsized rise in U.S. producer prices in September underlined the potential for inflation to take hold in the goods markets. Both have the potential to destabilize real economies.

After having been sent reeling the previous Friday by an uptick in oil prices related to new jitters in the Middle East, the bond market was blindsided Wednesday when Alan Greenspan took the occasion of testimony before the House Budget Committee to warn that economic and financial nirvana had not been attained. The present rate of economic growth is "unsustainable" while expectations that stock prices can continue to rise as they have in the past couple of years are "unrealistic."

Those utterances from the Fed chairman that drew so much consternation on the LIRR sent bond and stock prices tumbling Wednesday, with the benchmark 30-year Treasury bond losing 1 3/4 points in prices. And news Friday of a 0.5% jump in the producer price index of finished goods, more than twice the increase predicted by private economists, knocked bonds down further. For the week, the government long bond's net loss also was 1 3/4 points ($17.50 per $1,000 bond), which pushed its yield up 13.1 basis points, to 6.421%.

While Greenspan's comments would appear to be what you'd expect from a central banker, emphasizing the dangers and the downside of present conditions, they marked a stunning reversal in tone from just a few months ago. Last July, the Fed chief's supposed conversion to New Paradigm thinking was heralded on the cover of Business Week. The economy was now in Montana, the land without speed limits. As long as inflation didn't overheat, its new high-efficiency multi-valve engine could rev higher.

That inference was shattered by Greenspan's reminding the markets that speed limits remain. The economy can only grow as fast as the labor force expands, multiplied by the increase in the productivity of labor. Bodies times tools equal output, in other words.

Greenspan pointed out there is a limit to the rate of increase in the number of bodies, now that virtually that all want to be employed already are. And notwithstanding the heralding of a new age of productivity, evidence remains scanty. Thus, unless demand for labor slows down to supply, wage inflation will accelerate further, he concluded.

Paring demand for labor means slower growth. Unless the economy spontaneously slows on its own accord, the Fed will have to apply the brakes. That is, raise interest rates.

The Fed chief also again took note of the stock market's performance. While he stayed away from the infamous phrase "irrational exuberance" uttered 10 months (and more than 1,000 Dow points) ago, he did emphasize that expectations of the giddy rise of the past few years is unrealistic. Greenspan took note of the bull market's effect on the budget deficit. The surge in tax receipts hardly could be unrelated to capital gains equaling one-third of national income, he said. From this standpoint, the bond market has been a major beneficiary of the ongoing stockmarket rally.

Greenspan all but begged the question he explicitly raised in his "irrational exuberance" speech: To what degree should asset-price be taken to account in judging inflation? Deutsche Morgan Grenfell chief fixed-income economist Joseph Carson has constructed a broad price index to help answer that question.

This gauge gives two-thirds weight to the consumer price index, consistent with this sector's share of the gross domestic product. Producer prices (at the various stages of production, crude, intermediate and finished) get 12%, consistent with the costs of production. Real assets are given a 16% weight, in line with the investment and real-estate shares of the economy. Finally, financial assets are given a 5% weight.

Carson's broad price index is rising at a 6% annual rate and has been on an upward track since 1994. This gauge has paralleled the growth in the broadest money-supply measure, M3, which has expanded at an 8.5% pace over the past 12 months, the fastest in a decade. While these measures show money and prices rising apace, others point to the level of real (inflation-adjusted) short-term interest rates and the flat slope of the yield curve as indications of monetary restraint. How can that be reconciled?

Traditionally, if the central bank pegs the money rate at a high level, either deliberately to curb inflation or inadvertently (no government price fixer knows the right price), the bond market rationally expects interest rates to fall. To lock in those yields and to reap capital gains, investors buy longer-maturity bonds, lowering yields of lengthier maturities and flattening the yield curve.

But this does not appear to be the case now. The bond market's rally that had flattened the yield curve was the result of buying that was, in some part, speculative. Overseas investors, especially from Japan, could realize far higher yields in the U.S. Treasury market than their home markets. U.S. speculative buyers could realize a much larger "carry" by owning issues that traded as "specials" in the repurchase agreement market. Those scarce issues could be used for borrowings at far below the rate for "general collateral," which tracks the federal funds rate. Mortgage-backed securities investors also rushed into non-callable Treasuries to hedge against prepayments resulting from homeowners" refinancings. And if capital gains were forthcoming from an ongoing bond rally, the yield differential mattered little.

In any case, the growth of the money stock belies notions the Fed is artificially holding up the funds rate. And the flat yield curve as an indicator of restraint, especially given the performance of equity prices.

Indeed, what central bankers showed last week, either with words or deeds, is that stimulative monetary policies can go only so far in curing real economic ills. Beyond that, printing money just drives up prices, either for consumer goods or financial assets.

The Bundesbank's 30-basis-point hike in its repo rate, to 3.30% last week, appeared to recognize that fact. The record-high unemployment in Germany reflects the massive taxes and other disincentives, observes Brian Wesbury, chief economist of Griffin, Kubik, Stephens & Thompson of Chicago. Given these structural impediments, monetary ease threatens a pick-up of inflation in Europe. The mania for long maturities, at least prior to Greenspan's warnings, was best exemplified by the issuance of millenium bonds by Safra Republic Holdings, reportedly the first 1000-year maturity ever issued. The issue, priced originally at 92 basis points over the 30-year Treasury bond, apparently attracted scant attention.

While this was called the first-ever 1,000-year bond, during the nineteenth century some railroads issued perpetual bonds, according to Corporate Bonds, Structure and Analysis, co-authored by Richard S. Wilson and Frank J. Fabozzi. In addition, two railroads issued bonds maturing in only 475 years and another that came due in 999 years. As it happened, both issues came to be assumed by railroads that ultimately would be succeeded by the Penn Central Railroad, which filed for bankruptcy in 1970.

Ultra-long bonds have attracted bond portfolio managers because they provide a little extra yield, but their durations, which measure interest-rate risk, are little different from 30-year bonds. That's because the discounted present value of all those cash flows beyond 30 years are virtually nil.

The real risk of a 1,000-year bond isn't whether you'll actually see your principal repaid -- obviously, you won't be around -- but the chance that the issuer's here-and-now fortunes will deteriorate. While the yield curve is almost flat, the credit curve is more positively sloped, observes James Robinson, chief investment adviser for fixed income at Munder Capital Management. As a result, a three-year Walt Disney bond trades at tighter yield spread versus Treasuries than a 100-year Disney bond.

That means any deterioration in a company's earnings would translate into a sharp widening in the credit spread for an ultra-long corporate bond, which would result in a relative price decline. With spreads as tight as they've ever been, that's not a chance worth taking, says Robinson.

Better than bond math, the poet Shelley describes the hubris of believing your work will stand for centuries. Encountering a ruin in the desert, he reads the inscription:

"My name is Ozymandias, king of kings:
Look on my works, ye Mighty, and despair!"
Nothing besides remains. Round the decay
Of that colossal wreck, boundless and bare,
The lone and level sands stretch far away."
Of course, that risk is worth at least 10 basis points.

E-MAIL: Randall.Forsyth@news.Barrons.com