The Ominous Warning Signs of Recession
While the headlines fixate on George Bush’s launch as a “kinder, gentler” president, a potentially more momentous transition has occurred over at the Federal Reserve, the independent central bank that regulates money and interest rates. Without much fanfare in the press, the Fed has, so to speak, flicked on the yellow warning light for the American economy. If the light stays on long enough, this new president will find himself staring at a recession, as well as swelling federal deficits.
The ominous signal is reflected in what the governors of money have done to interest rates. For the last eleven months the Fed has been gradually tightening the money supply, pushing short-term interest rates higher, a notch at a time. Fed chairman Alan Greenspan’s purpose was to slow things down gently and avert what financial markets feared might be a new breakout of inflation. The economy seemed to plow ahead regardless, and most forecasters remain optimistic about 1989.
But in the final weeks of 1988, the Fed’s campaign took a portentous turn — producing a rare, abnormal condition in credit markets that ought to alarm our political leaders. Thanks to the Fed’s tightening, the interest rates paid on short-term investments, such as one-year treasury bills, have now risen above the rates paid on long-term investments, such as thirty-year government bonds. That’s illogical on its face, since investors normally earn more on long-term lending, because it is more risky.
In financial markets this upside-down condition is known as an inverted yield curve, which occurs only when the central bank is putting extraordinary pressure on the supply of money that circulates through the vast labyrinth of American commerce and credit. It means money is extremely tight. It also usually means a recession is coming.
The last time we had an inverted yield curve was in the early 1980s, just as Ronald Reagan was taking his oath of office. Six months later the economy sank into a long and bloody recession, which simply means that the gross national product — production, sales, jobs — declines. Democrats and other Americans blamed Reagan and his supply-side economics, but their anger should have been directed at the Fed. The central bank has the unique power to go its own way — even when it means opposing the president.
If history is any guide, George Bush’s presidency is already at risk. The rules of modern economics are regularly refuted by real events, but this is one rule that has held up remarkably well over the years. Since 1950 there have been nine occasions when short-term rates were pushed above long-term rates and held at that level for many months. Seven times a recession followed. The two exceptions, when the inverted yield curve did not lead to a full-blown contraction, occurred between 1966 and 1968 when the Fed backed off in time and eased credit. The economy was also stimulated then by vast spending for the war in Vietnam. Even so, those episodes produced a dramatic slowdown that economists remember as a “minirecession.”
There’s nothing especially mysterious about why abnormally high interest rates put the economy in the tank. The cost of credit is embedded one way or another in most transactions. Higher borrowing rates drive away home buyers and keep customers out of auto showrooms. Businesses that must borrow to maintain their inventories begin cutting back their orders for new goods when their sales decline. Pretty soon the factories are cutting back production and sending the workers home. If this process gains enough momentum, the overall economy stops growing and begins to contract. Borrowers begin to default on their debts — both unemployed workers who can’t keep up with their mortgage payments and businesses suffering from lost sales.
The smart people in financial markets know this history and understand its implications for today. This early in the Bush era, they are not yet predicting that a recession is inevitable, but they are issuing sober warnings. Barclays Bank of London recently told bond buyers that U.S. money policy is “now tight enough to risk a harder landing for the real economy than markets have discounted.” Edward Yardeni, chief economist at Prudential-Bache, has complained for months about what he calls “the Greenspan error” — the danger that the Fed will hold too tight and inadvertently sink the economy. “It’s nice to prove you’re macho about fighting inflation,” says Yardeni, “but if you overdo it, what’s the point?”
So is the Fed going to rain on George Bush’s parade? Certainly a recession is not what voters thought they were buying when they opted for another four years of Republican “Don’t Worry, Be Happy” prosperity. Nor do I think this is the result Bush and his advisers have in mind. Yet so far nobody in the administration has complained about the Fed’s policies.
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