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Get Four
|  | MARCH 27, 2006
By Chris Farrell Let the Good Times RollThe Fed chief's speech may have left investors scratching their heads, but the underlying feeling is that we're in for a long-term boomFederal Reserve Board Chairman Ben Bernanke gave a highly anticipated speech before the Economic Club of New York last week. Investors held their collective breath but in the end were disappointed. The former Princeton University economics professor tackled one of the more fascinating financial puzzles of our time, what his predecessor Alan Greenspan called the "conundrum" -- why is it that long-term bond yields barely budged even as the Fed hiked its benchmark interest rate 14 times over the last 21 months? Bernanke ran through the possible explanations. He gave credence to the argument that a global savings glut was keeping bond yields down, and cast doubt on the popular explanation that purchases of Treasury bonds by Asian central banks is the cause. He managed to leave everyone confused about the implications of the current yield curve for future monetary policy. In a sense, it was a classic economist's "on one hand/on the other hand" performance. What investors likely took away is that the Fed will hike its benchmark interest rate to 4.75% when it meets this week. BACK TO THE FUTURE. Nevertheless, despite all the twists, hedges, and cautious asides, a much bigger theme emerged from Bernanke's speech. He believes that real bond yields have taken a fundamental step down. If he's right, and I think he is, the significance of lower real rates is a seismic event for everyone from a young, first-time homebuyer to a grizzled venture capitalist. Put it this way: The world economy is on the cusp of an era of nonexistent inflation and rapid economic growth -- a long boom of historic proportions. First, let's deal with inflation. In a sense, it's back to the future. Until the late 1960s, inflation was essentially zero in the U.S. outside of major wars, such as the Civil War. The runaway peacetime inflation and high bond yields of the 1970s represented a dramatic break from U.S. economic history. The peacetime inflation and the high interest rates that accompanied it largely represented missteps by an incompetent Fed that ran too loose a money policy for too many years. The new economy of close to zero inflation comes from the confluence of three fundamental changes set in motion about a quarter-century ago, forces that have converged, reinforced one another, and gained energy over the years. PAST MISTAKES. The first is globalization, the embrace of market capitalism at home and abroad. The competition for markets, profits, and jobs is white hot, keeping managers and employees on their toes, encouraging creativity, and keeping prices down. Second is the Internet and other advanced information technologies. Then there is an international monetary system based on a shared commitment among central bankers that their main job is to prevent an outbreak of inflation. They've learned from past mistakes. For instance, even though inflation is relatively tame, the Fed, the European Central Bank, the Bank of Canada, and the Bank of Japan are all running tight monetary policies. Keeping central banks committed to their anti-inflation stance are the $100-plus trillion world capital markets. To be sure, there will be periodic spikes in inflation (and deflation for that matter). But inflation isn't about to make a sustained rise. The impact on the yield curve could be dramatic. The real yield on the 10-year Treasury during the past five expansions averaged 4% to 5%, according to Nariman Behravesh, chief economist at consulting firm Global Insight. This time around, he says, it has been averaging 2%. And William Gross of PIMCO, one of the most successful and influential bond fund managers in the world, argues that the real rate is heading toward 1%. A range of 1% to 2% is reminiscent of the 19th and early 20th centuries. GROWING ACCESS. "Economic expansions in the 1800s were often characterized by rising real growth without inflation" --sounds like the Greenspan era -- "pushing short-term yields up to finance real growth but leaving long-term yields unchanged since inflation never emerged," says James Paulson, chief investment officer at Wells Capital Management. Peter Bernstein, the New York finance economist, says: "In an environment where expected inflation over the long run is essentially zero, but where short-term rates swing up and down with business activity, the short rate is going to be higher than the long rate on frequent occasions." Low real rates will encourage a lot of investment. And this is where the integration of developing nations into the global capitalist system becomes important. The spread of capitalism, especially to China, India, and most of Asia, is invigorating growth by providing entrepreneurs from most of the world's developing nations access to bigger markets. THIS IS DIFFERENT. Paulson notes that just as demobilized soldiers went home after World War II and began rebuilding the economies of the major industrial nations, now developing nations with young populations and tremendous infrastructure needs are driving growth in their economies. "As emerging-market labor force and job growth surge, rising income and spending growth are sure to follow," says Paulson. "Just as Americans built homes and proceeded to fill them with consumer goods in the aftermath of World War II, today a similar blueprint is being followed by emerging economies." John Templeton, the elder statesman of global investing, famously remarked that among the four most costly words in market history are "this time is different." Yet we all share a sense, from the factory floor to executive suites, that something new is going on in the global economy. And that something new is optimism. For the first time in history, almost everyone in the world economy has a chance for a better life -- or at least their children do. Let the long boom begin.  Farrell is contributing economics editor for BusinessWeek. You can also hear him on Minnesota Public Radio's nationally syndicated finance program, Sound Money, as well as on public radio's business program Marketplace. Follow his Sound Money column, only on BusinessWeek Online
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