Greenspan and the Virtue of Fantasy

Investors hope for higher earnings ... and that'll lead companies to spend more. Or so it goes.
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As was widely expected,

Federal Reserve

Chairman Alan Greenspan offered some upbeat views on the economy during the first part of his two-day congressional testimony Tuesday. Somewhat unexpectedly, the chairman's cheerleading was not limited to the economy. He also tossed a few pom-poms toward Federal Reserve's policies; in other words, at his own feet.

In sum,

this testimony is basically about a virtuous cycle of lower rates leading to better balance sheets and higher asset prices, ultimately leading the economy out of its sluggish state. It's also about a feedback loop involving the Fed, financial markets and consumers that currently seems to be working as intended, but not entirely (especially given the Treasury market's wicked selloff Tuesday) and with no guarantee of future success.

In his semiannual testimony, formerly known as Humphrey-Hawkins, Greenspan effectively outlined how the Fed's "highly accommodative stance" -- i.e., lowering the fed funds rate 13 times since January 2001 to its current 1% -- has helped both businesses and households "restructure and strengthen balance sheets."

These improvements have been "assisted by" higher asset prices, which helped household net worth rise by 4.5% in the first half of 2003, Greenspan testified. This increase in household wealth has also been facilitated by rising real estate prices and record-setting refinancing activity. Of course, low interest rates have played a key role in the housing and related-credit boom.

Low rates also have helped corporations lower their debt service costs, resulting in "a decline in the ratio of business interest payment to net cash flow, a significant increase in the average maturity of liabilities, and a rise in the ratio of current assets to current liabilities," Greenspan declared.

Meanwhile, the aforementioned higher asset prices have prompted households to "shift their portfolios in favor of riskier assets," he said, citing recent "sizable inflows" into equity mutual funds and corporate bond funds.

Bye-Bye Mr. Bond

Greenspan did much to undermine demand for less-risky assets on Tuesday. Long-dated Treasury prices tumbled, owing both to the chairman's largely upbeat outlook for the economy and his dampening of hopes the Fed would take unusual steps to lower rates, presumably including buying long-dated Treasury securities. "Given the now highly stimulative stance of monetary and fiscal policy and well-anchored inflation expectations, the committee concluded that economic fundamentals are such that situations requiring special policy actions are most unlikely to arise," Greenspan said.

The price of the benchmark 10-year Treasury fell 1 26/32 to 99 12/32, its yield rising to 3.95%. The price of the 30-year bond fell 2 27/32 to 106 12/32, its yield rising to 4.95%.

"The Fed has become more tolerant of rising inflation risks and that wasn't playing too well in the Treasury bond market," said John Lonski, senior economist at Moody's. "He's not saying 'buy Treasuries'

but that if you want to invest, you're better off looking at stocks or corporate bonds."

Lonski forecast a 10-year yield approaching 5.50% by year-end 2004, citing the Fed's effectively pro-inflation stance, along with upward price pressures in industrial metals, real estate, health care, education and most other services -- not to mention crude's stubborn refusal to decline below $30 per barrel. "Be prepared for significantly higher Treasuries yields," he warned.

In contrast with Treasuries, the decline by stock proxies was tame. Still, shares failed to sustain early intraday highs for the second-consecutive session.

After trading as high as 9238.01 on the heels of a better-than-expected July retail sales report, the

Dow Jones Industrial Average

closed down 0.5%% to 9128.97. The

S&P 500

shed 0.3% to 1000.42 vs. its intraday best of 1000.61, while the

Nasdaq Composite

slid 0.09% to 1753.28 after trading as high as 1771.78.

Holes in the Loop

Getting back to Greenspan's virtuous cycle theory. To summarize: the Fed lowers rates, which helps business/households improve their balance sheets, which leaves them flush with cash, prompting them to "shift their portfolios in favor of riskier assets," which helps pump up financial markets. That, in turn, prompts excitement that stocks (and bonds) must be saying


about future corporate profitability.

That's crucial because rising profits are key to reviving capital spending, something Greenspan acknowledged remains elusive. "As yet, there is little evidence that the more accommodative financial environment has materially improved the willingness of top executives to increase capital investment," he testified.

The chairman suggested the "recent intense focus on corporate behavior" is the main impediment to risk-taking by executives. But he conceded, "still ample capacity in some sectors and lingering uncertainty about the strength in prospective final sales have added to the reluctance to expand capital outlays."

Effectively closing the loop between the Fed chieftain and financial markets participants, Greenspan cited "investors' outlook" (vs. past references to "sell-side analysts") for better corporate earnings as a potential sign of a pickup in capital expenditures going forward. Expectations for better corporate earnings seemingly provide the chairman faith that capital spending will revive and that (


) his aggressive rate-cutting policies really are the panacea for what ails the economy. (No, really!)

Not Too Hot, Not Too Cold

As reported

here last month, almost all appears to be going according to Greenspan's plan. The one major sticking point, which the chairman acknowledged, is the issue of capital expenditures. Maybe the chairman is correct that the combination of accommodative monetary policy and the "heavy dose of fiscal stimulus now in train should bolster economic activity over coming quarters," ultimately leading to higher capital spending.

Such an outcome would justify (to some degree) recent gains in the stock and corporate bond markets, as well as Wall Street's general optimism about future economic growth.

Then again, the completion of Greenspan's loop will have to occur despite (among other head winds): rising federal budget deficits (the White House raised estimates for fiscal years 2003 and 2004 Tuesday); subpar GDP growth; still lackluster corporate profit growth; rising unemployment; record-setting personal bankruptcies and rising mortgage delinquencies; and 20-year-low capacity-utilization rates, stemming from overcapacity in many sectors, something Fed policies may be

helping to sustain.

In the late 1990s, there was a lot of talk about the "Goldilocks economy." Those starting to believe again in Greenspan's "magic powers" are still living in fantasy land.

Aaron L. Task writes daily for In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

Aaron L. Task.