What's on Greenspan's Mind?

By Daniel Kadlec

Alan Greenspan raised interest rates. Again. Nobody noticed. Again. This has been going on for a year--nine rate boosts, all met with indifference by the financial markets. If the trend lasts much longer, the housing bubble will graduate to a full-size blimp, and there may be no avoiding its fiery crash.

Alarmist? Perhaps. Yet the Federal Reserve Chairman clearly harbors thoughts of disaster. He's been speaking of "froth" in the housing market for weeks, and--unable to coax mortgage rates higher--has publicly admitted that he doesn't know how to regain his grip on the economy. In February he called the situation a "conundrum" and then last month added that "the economic and financial world is changing in ways that we still do not fully comprehend."

Here's the puzzle: the maestro has been trying to orchestrate a rise in long-term interest rates, but the usual tactic--raising, as he did last week, the short-term rates that he directly controls--has not worked. The 10-year Treasury bond yield has plunged to 4%, from 4.7% a year ago. As bond yields have fallen, mortgages--ground zero for housing froth--have followed. This has occurred against all odds; in the same period, short rates rose from 1% to 3.25%, and the economy was gathering momentum.

If you're an individual buying a house or a CEO erecting a new plant, you may well say, Who cares? Or better still: bravo! Falling long-term rates make it easier to finance such projects. Yet easy financing is exactly what the Fed wants to eliminate this deep into a recovery. Greenspan is worried that too much easy loot has found its way not just into housing but also into many other things. Low rates do that--encourage home buyers to overpay, investors to overcommit and companies to overbuild. Greenspan hopes that by nudging rates up, he can slow investment without causing a crash. "Some industries would be better off with a shake-out" to kill speculative juices, says Ed Yardeni, economist at Oak Associates. The Fed is doing its part. But bond traders, who usually take the cue and push yields higher as the Fed drives up short rates, are not playing along.

There are many theories as to why. The most prominent is that the economy is headed for a slowdown, which typically is why bond yields fall. Yet last week GDP was revised upward to a robust 3.8% for the first quarter, and Greenspan has noted that "periodic signs of buoyancy" have not stopped the decline.

Another possible cause is the relentless march of baby boomers toward retirement. Pension-fund managers are preparing for the coming wave of payouts by shifting into T-bonds, this theory goes, and the incremental demand is driving prices higher and yields lower. Yet, says Greenspan, "world demographic trends are hardly news." Additional demand for T-bonds is coming from our trading partners, particularly in Asia. But the impact on rates has been "modest," Greenspan has said, and the downward trend in yields has not let up even when foreign buying of T-bonds has slowed. Finally, some argue, expanding global trade and outsourcing are making competition so fierce that inflation--always a bond-market bugaboo--will remain low for many years, keeping interest rates low even as the economy grows. Sound reasoning but, again, not new.

If Greenspan is perplexed, it may just be that he's looking too hard--or is loath to acknowledge his role in the conundrum. The flood of easy money generated on his watch to rescue the economy from the burst Internet bubble and other threats has found its way into everything--from oil, gold and timber to stocks, bonds, real estate, art and the price of a Mickey Mantle rookie card. Nothing is cheap. With no bargains to be found, future returns are bound to suffer. T-bond yields reflect the market's best guess at long-term, risk-free returns. Stubbornly low yields are an acknowledgment of the new reality: today a near certain 4% return looks pretty darn good.

Greenspan no doubt has his legacy in mind. He's only six months from leaving the Fed and, says Bill Gross, chief investment officer at fund company Pimco, "doesn't want to go out with the reputation of having created a bubble." But there's little Greenspan can do about it as long as investors are thinking about their own legacies: buying bonds now because nothing else looks better.