ABSTRACT
Greenspan’s congressional testimony of July 1993, containing a startling announcement of a new policy target (see chapter 4 above), made it clear that the Fed was ready to slow down the U.S. economy in order to prevent its overheating. The chairman of the Fed, however, did not act immediately upon his pronouncement, as the U.S. economy unexpectedly cooled off for a few months. But by late 1993 activity suddenly reaccelerated to boom levels, and in February 1994 the Fed began the promised tightening with the first in a series of modest rate hikes. Over the next year the central bank would push up the Federal funds rate and/or discount rate seven times to twice their pretightening levels. The Fed characterized this policy course as a preemptive strike against future inflation that would reinforce its “credibility” as an inflation fighter and thus convince financial markets to accept lower long-term interest rates. Ironically, when the Fed began to raise short-term rates, bondholders and currency traders acted in precisely the opposite way. Suspecting the central bank of having acted on some “inside” information about inflationary pressures, these financial investors pushed long-term rates quite a bit higher. Instead of flattening, the entire yield curve simply shifted upward. Eventually, as the Fed continued pushing short-term rates up in the face of slowing growth, the fears in bond, stock, and currency markets subsided and the long-expected decline in long-term rates finally took hold. In the meantime, however, the bond market in particular suffered from a steep and sustained decline in prices, which triggered a series of spectacular losses by investors using complex derivatives tied to the performance of bonds and stocks (e.g., the bankruptcy of Orange County). 1
