Sunday, September 16, 2007 0 comments ++[ CLICK TO COMMENT ]++

Greenspan's Book: Inflation Likely Higher in the Distant Future

I ran across The Wall Street Journal's quick summary of some of Alan Greenspan's thoughts in his new book, The Age of Turbulence: Adventures in a New World. The part I found insightful is where he talks about his expectation for higher inflation and the need for far higher interest rates over the next 25 years. (I bolded some key words in the quote below)

In coming years, as the globalization process winds down, he predicts inflation will become harder to contain. Recent increases in the price of imports from China and a rise in long-term interest rates suggest "the turn may be upon us sooner rather than later."

Left alone, he said, the Fed's policy-making body, the Federal Open Market Committee, can keep inflation between 1% and 2%, but that could require forcing interest rates to double-digits, a level "not seen since the days of Paul Volcker," his predecessor as Fed chairman. "I fear that my successors on the FOMC, as they strive to maintain price stability in the coming quarter century, will run into populist resistance from Congress, if not from the White House," he writes.

If the Fed succumbs to that pressure, inflation could rise from a little over 2% at present to an average of 4% to 5% by the year 2030, he writes. Ten-year Treasury yields, now below 5%, will rise to "at least 8%" with the potential to go "significantly higher for brief periods." This, he says, will lead to stagnant returns on stocks and bonds and much smaller gains in housing prices.

(source: Greenspan Book Criticizes Bush And Republicans, Greg Ip and Emily Steel, Page A1, September 15, 2007, The Wall Street Journal Online; URL:

This isn't really anything new but I found it surprising that he thinks that you need 10%+ interest rates in the future. A rise in interest rates over the long term was almost inevitable given that the rates are low by super-long-term historical numbers (people in the 80's and 90's have been spoiled by the decline of interest rates to low single digits). Needless to say, higher interest rates will depress asset prices (since future cash flow from assets are discounted to the present using a given interest rate).

I don't agree entirely with Alan Greenspan's view. I do think interest rates will go up to combat inflation but there will still be deflationary pressures to keep them down. A key criteria for Greenspan's view is his expectation of Globalization winding down (bolded in the quote above) but I don't see that happening for a long time. Since I believe free markets are the ideal system, there are still a lot of countries that are not part of so-called Globalization. Many Latin American countries that are not commodity exporters, some African countries, and some protectionist Asian countries have not participated. The process will continue as these countries switch their econopolitical systems. Even for the big countries that have opened up their markets, they are still a long way from exerting inflation on the rest of the world. For example, if you look at some country like India, the vast majority of its economy is still quite primitive (agricultural, inefficient retail, etc) so there will be defltionary pressures exerted by workers in those areas changing jobs, or the development of new technology to satisfy the changes.

Having said all that, we can be sure about one thing: returns on stocks (at least for developed countries) will be lower in the future than they were in the last 25 years. If this is the case, I suspect passive indexing will underperform active investing--this is another reason I'm more keen to develop some skills in value investing, stock picking, and so forth.


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