A double bubble of the Fed's own making

First published in the UK edition of the Financial Times, 8 July. The writer, Melvyn Krauss, is a senior fellow at the Hoover Institution, Stanford University.

In pulling the rug out from under global bond markets, Alan Greenspan, chairman of the Federal Reserve, has done Wim Duisenberg, his counterpart at the European Central Bank, a big favour.

He has undermined the popular myth that it is Mr Duisenberg and the ECB that have problems communicating with markets - unlike the Fed, which is a paragon of virtue and effectiveness when it comes to getting its message across.

But who could fairly criticise the ECB now that the Fed has misled investors so badly and caused financial carnage by cutting only a quarter of a percentage point off interest rates at its June meeting - after sending numerous signals to the markets that a half-point cut was in the offing? Who could argue that the ECB has the monopoly on poor communications, given the Fed's subsequent communique - a badly worded and confusing text apparently intended to clarify and explain the Fed's stance on the economy?

This is not the first time Mr Greenspan's credibility has come into question. To his critics he is the "double bubble" man. First, Mr Greenspan egged on the stock market to bubble proportions with incessant happy talk about the alleged limitless capabilities of US productivity.

That story did not have a happy ending, as we all know.

Then, in the run-up to the June meeting of the Federal Open Market Committee, Mr Greenspan, in numerous public addresses, inflated a bond market bubble. He did so with talk of a so-called deflation problem that might require the Fed to adopt non- conventional means of monetary stimulation - in particular, buying bonds at the longer end of the yield curve.

Such talk caused an unusual drop in US 10-year yields, from 3.9 per cent to about 3.1 per cent in just six weeks. Reverberations from Mr Greenspan's bond-friendly public statements were also felt in Europe. The argument doing the rounds in European financial circles was that by publicly encouraging fear of deflation in the US, the Fed was exacerbating the deflation problem in Germany by further building up German deflationary expectations. Moreover, the US bond bubble was creating an unwanted European bond bubble as well.

Suffice it to say that the Fed's credibility suffered a significant blow when, at the June FOMC meeting, it opted to economise on its scarce supply of conventional bullets rather than push the new frontiers of monetary policy.

There is nothing wrong with this, of course - perhaps a 25 basis point cut was the right thing to do in the circumstances - but why, one wonders, did the Fed chairman mislead so many people in the marketplace to believe the opposite?

The unpleasant truth is that Mr Greenspan and his colleagues first created the bond bubble with their radical rhetoric, then burst it with their conventional actions.

Of course, few will shed tears for the bond market speculators who made the wrong Fed bet. But the extraordinary and unnecessary volatility the Fed has imposed on financial markets and the US dollar could have adverse consequences for the real economy.

Mortgage rates surely will jump and threaten another of Mr Greenspan's bubbles: the housing market. Moreover, the Fed's loss of credibility will undermine its ability to guide the economy through the storms that are currently gathering. In particular, if deflation becomes a real problem in the US, the Fed's capacity to engineer looser financial conditions without cutting rates has diminished along with its credibility. This is an important consideration when ammunition is in such short supply.

Some Europeans may take comfort from the Fed's troubles but this is not a situation in which bad news for the US is good news for Europe. The US economy must recover in order for Europe to do so, and the Fed's loss of credibility may well slow down the US recovery.

Still, the frequent attacks on the ECB and Mr Duisenberg in both the markets and the media have often had as their implicit assumption the view that the Fed would do it better.

This was always unfair. But now we know that it was untrue as well.

Mr Greenspan is the "double bubble" man - not Mr Duisenberg. The Fed's fall from grace is valuable if only for putting the achievements - and shortcomings - of the ECB and Mr Duisenberg into proper perspective.