Greenspan is fighting a demon of his own making

As Greenspan approaches the end of his run as Fed chief, he’s attempting to paint himself as a New Era Paul Volcker, vigilant against inflation to the end. But the fact is, Greenspan’s mythos is more akin to Don Quixote or Robin Williams’s character Parry from the wonderful 1991 movie The Fisher King.

Greenspan is fighting a demon of his own making - risk. Greenspan attempted to redefine the Fed as a risk-manager, charged with shielding the US economy from extreme financial risk. But as any trader, athlete or CEO will tell you, you have to play to win. If you play not to lose, you’re usually stuck with the very outcome you sought to avoid.

In 1996, when the Russian default threatened the global economy, Greenspan’s response was to slash rates in an effort to lessen the effect of bad investments by the likes of mega-hedge fund Long Term Capital Management (LTCM), at a time when the US economy was expanding. The result: stock market bubble.

In 2002 and 2003, the fear of deflation led Greenspan to drop rates to all-time lows. The result: massive real-estate appreciation.

Now, in the face of a slowing economy and high energy prices, rates are going up. Greenspan seems intent on choking economic growth to fight inflation.

Here’s the simple fact: you can’t remove risk from an economy. In fact, capitalism openly embraces risk. Successful people are the ones who aren’t afraid to risk it all. Timid people avoid risk. But what do we call those who, like Don Quixote, treat risk avoidance as a mythical struggle between good and evil?

Atlanta Fed President Jack Guyn said the Fed has a way to go before it is done hiking rates. His concern is that high energy costs will get passed on to the consumer.

Umm… costs are already getting passed on to the consumer. Probably US$120 a month for my family, just in gas prices. And once winter gets here, I’ll be throwing an additional US$200 a month on the bonfire.

Does the Fed really think that monetary policy can somehow prevent price rises due to energy costs? I hope not. That’s the economic equivalent of fighting windmills.

More likely, the Fed is aware that the economy will slow as energy costs get passed through. And the only way the Fed will be able to ride to the rescue (again) is to have rates higher than they are right now.

Of course, it won’t be Greenspan riding to the rescue. His term ends in January 2006. The new Fed Chief will inherit a healthy dose of imbalances as well as some interest-rate ammunition.
If history is any guide, he or she will be busy from the get-go. The last few Fed changes have been difficult. Arthur Burns became Fed Chairman in 1970 right before the oil crisis. Paul Volcker got the job in 1979 in the midst of runaway inflation. And Greenspan took over two months before the October 1987 crash.

The next Fed Chairman will likely inherit a US economy hampered by high energy prices, slowing consumer spending and stagnant or falling real-estate prices. And I wouldn’t be surprised if there’s a little instability from China thrown into the mix.

With so much focus on energy, there are some very interesting - and potentially profitable - developments right now. This is a topic I will be returning to in the future, so stay tuned!

Sincerely,Briton L. Ryle
Chief Trading Strategist
Money-Flow Matrix Trader