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"Mission Accomplished" & the Inverted Yield Curve

November 17, 2006

In a speech entitled — with breathtaking hubris — "The Worldwide Conquest of Inflation", the neophyte Fed Governor Randall Kroszner quotes Hayek's proposals for currency 'denationalization' as support for his thesis that competition between fiat currencies has somehow encouraged a 'race to the top' among them, thus retarding the ongoing debasement of our monies.

Those of us whose lot it is regularly to read financial reports and economic data releases - and who are therefore continually bombarded with tales of the record issuance of credit instruments, the record turnover and growth rates of the associated financial derivatives, as well as record M&A and LBO activity (all of this, in great part, conducted at record low credit spreads or exceedingly high leverage ratios, accompanied by unusually lax loan covenants and amid record low measures of financial asset volatility) — may here allow ourselves a wry smile at Mr. Kroszner's gross misunderstanding of what constitutes 'inflation'. Kroszner also makes an attempt to deal with the phenomenon of the negative yield curve which has been exercising so many stock-watchers and macro-forecasters of late.

Warming to his theme, the Governor puts it all down to "the combination of lower and less volatile inflation around the world" which — under benign central bank guidance, of course - has led to "a reduction in inflation expectations and lower perceived inflation risk, and hence to a lower premium in long rates for inflation uncertainty... important contributors to the lower long-term yields and the flattening of yield curves."

Thus, Kroszner attaches a benign explanation to what the empiricists have been touting as a sign of our impending cyclical doom. Though we can dismiss his over-sanguine explanation almost as readily as his boss's gibberish about a 'global savings glut', we should also note that the pessimistic consensus has taken past correlation blindly to imply causation and has, in typical fashion, failed to conduct any deeper, rational inquiry into why inverted yield curves often signal an imminent end to the boom and why therefore they are never a sufficient condition for the relapse (and may not even be a necessary one).

As I wrote in a recent report to my company's investors, the bust comes about when the degree of overstretch and disco-ordination in the productive structure - which the boom's inflationary fuel has progressively induced — at last becomes a widespread and binding constraint upon the further execution of misplaced entrepreneurial activities:

"... it is this combination of a scramble for the necessary co-factors to one's own output (many of which may lie well downstream) and the associated dwindling of cash flow which tends to push up real short-term interest rates at the same time that the strident disharmonies in the structure discourage or disable longer-term investments and so lessen the pressure on long rates."

"This is why an inverted yield often presages a crisis, since the exigent demand for money which twists time rates in this fashion is, in effect, a signal of a generalized scarcity of present goods: to borrow a term from commodity markets, it is akin to a widespread 'backwardation' of circulating capital, of a dire lack of the needed complements to all too many misconceived productive plans."

"Thus, contrary to the many who rely, not upon a theory as to why this should be so, but only upon a happenstance of the statistical record, it is also why such an occurrence should be disregarded when, as today, it is not accompanied by elevated real short rates, falling profits, rising risk premia, and direct evidence of credit restriction, but, rather, is only an artefact of prodigious, leveraged purchases of longer-dated securities acting in concert with a vast government programme of foreign exchange intervention through the same medium of the bond market."

Or, as Hayek put it, the truly ominous aspect of a negative yield curve is that which arises in a situation where 'investment raises the demand for capital' and not when inflation itself — properly defined — is boosting the price of riskier financial assets and thus suppressing long bond yields.

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