Greenspan Speaks, I Listen

Today Alan Greenspan made several interesting comments: He stressed that longer-term inflationary pressures are rising, that agricultural price increases are not a mere short-term anomaly and that the potential costs of making a mistake in monetary policy are going up. In other words, watch out all you central bankers, if you cut rates too much you may end up with a big structural inflation problem in your hands. (Yes, this means you too, Mr. Bernanke). He also mentioned that measuring CPI inflation ex-food and energy is becoming increasingly less valid, but anyone who has been going to the supermarket in the past 12 mos. already knew that. Perhaps now that he has a bit more free time he pays closer attention to milk and cookie prices.

All of this may just be a "phantom Fed" condition for the ex-Chairman, like the person with an amputated hand or leg still "feeling" the lost limb, but I don't think so. His one true professional love has always been forecasting and that's why he was, on the balance, a successful Fed Chairman: he actually paid much closer attention to real business conditions instead of solely relying on Wall Street. What he is doing right now is forecasting the economy and doing so publicly - and for free! (Well, it does sell books).

But, all of a sudden, though everyone is listening to what he is saying, no one is paying attention. Gone are the days when Fed watchers would hang on his every phrase and punctuation mark to fathom his "real" thoughts. For example, he keeps on stressing that the US economy has a more than 33% and under 50% probability of going into a recession soon and has even recently raised this probability from a central 33%. The reason, he claims, is that 15% of personal consumption is a direct function of the wealth effect created by higher real estate and equity prices, chiefly through home equity loans and second mortgages. Since the rate of growth in US household net worth is flattening out, consumption is going to be affected - thus his recession probability predictions.

So, here is a chart of what Mr. Greenspan is talking about viz. household net worth (click to enlarge). The last data point is the second quarter of 2007, which is running at an annualized inflation-adjusted growth rate of 3.8%, which would have been even lower had it not been for shares going higher. The corollary is that if household wealth continues weakening - and it certainly was hit hard in the third quarter that just ended - then consumer spending will suffer, i.e. a recession.

Data: Federal Reserve

You would think that markets should be pricing this into their forecast for corporate earnings and adjusting share prices and risky debt accordingly, but no such thing is happening. Indeed, something else entirely appears to be at work: namely, a concerted effort to salvage household net worth (and thus consumer spending and the whole economy) by pumping share prices higher to mitigate lower real estate values. Call it manipulation, propaganda, convincing foreign "friends" to intervene with their (our) dollars... whatever. But this I can say, coming from my "stomach" where at least two decades of daily professional market experience resides: the probability of something out of the ordinary going on is more than 50% and less than 100%.