How We Missed Signs Of A Slowdown

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The trickle of bad news among techs turned into a flood. "The breakthrough came last spring, when investors recognized that the business model used by many Internet firms just wasn't going to work," says Ken Shea, director of equity research for Standard & Poor's. Result: the market value of Internet-related companies alone plunged nearly $1 trillion from its March 2000 apex. Never before has an industry skyrocketed to such heights and then plummeted to such abject depths with such blazing speed.

"Investors are continuing to go to where the stocks are doing well, and that's the NASDAQ." --Robert Freedman, executive vice president of John Hancock High Net Worth Funds (Los Angeles Times, Feb. 18, 2000)

Never, Never Ignore Greenspan
Investors are supposed to frighten easily, especially when the Federal Reserve raises interest rates to battle inflation. A tightening monetary policy slows economic growth and hurts corporate earnings and stock prices. But instead of being unnerved by Chairman Alan Greenspan's round of rate hikes the past two years, investors yawned.

The Fed, which was worried about the inflationary impact of our wild shopping frenzy along with a near tripling in oil prices, lifted interest rates three times in 1999 and twice more in the first three months of 2000. Did anyone get the hint? Nope. Investors were too intoxicated by the enormous money being made in the market. The pain of costlier credit was more than offset by all the paper wealth people were accumulating.

Greenspan took off the gloves. The central bank pushed rates up half a percentage point in May, the largest single hike in five years. The benchmark federal- funds rate jumped to 6.5%, the highest in nine years. Now Greenspan had committed to a course that would bring the economy to heel. Or to rest.

"The Federal Reserve would have to clamp down on interest rates aggressively to stop this expansion, and that is very unlikely." --Economist Maria Ramirez, president of MFR Inc. (Wall Street Journal, Jan. 3, 2000)

Who Inverted My Yield Curve?
When interest rates on short-term government debt shoot past those on long-term bonds, it is a phenomenon known as an inverted yield curve. And it's bad. Normally, investors with longer-term debt receive a higher interest-rate payment than those holding shorter-term securities. That's because there is a bigger risk that inflation will hurt the value of a 30-year Treasury bond over time.

But in January 2000, the unusual happened. The Federal Reserve's tight monetary policy led short-term interest rates to climb close to 7%, while bonds were around 5%. An inverted yield curve is one of the most reliable predictors of tough economic times ahead. Eight of the past nine recessions were preceded by such an event. The last time the yield curve inverted was a decade ago, just before the onset of the 1990 recession.

Why is it such an effective gauge? Because it's the clearest evidence that money is getting increasingly scarce. Yet few people took the sign very seriously.

"Normally, that signals kind of a very significant economic slowdown. I don't think that will be the case, but I think we are on the way of kind of slowing this economy down to a soft landing." --Ed Brown, president of a money-management firm in Baltimore, Md. (Wall Street Week, Feb. 4, 2000)

Pop Goes Petroleum
Oil has proved to be the Achilles' heel of the economy in the past. In fact, higher energy prices played a role in each of the past four recessions. In every instance, more expensive energy forced businesses to pass on the extra costs to consumers. Workers also demanded more pay to offset the higher cost of living.

Now trouble was brewing again. Since crude oil prices had doubled by January 2000 and hit a decade high three months later, economists were starting to be worried about how badly business activity would be harmed even though oil was not as big a component in the economy as it had been in the '70s. Still, Fed Chairman Greenspan feared the latest spike in energy prices might fuel inflationary pressures again.

Surprise! The danger turned out to be the reverse: the economy didn't suffer from a sharp breakout in inflation. Instead the hike in energy prices led to deflation. The oil shock was the equivalent of a $100 billion tax increase on consumers and businesses. Result: the erosion in purchasing power forced ceos as well as ordinary consumers to cut back on spending. Since such general expenditures make up more than 80% of all economic activity, the economy took a beating in the second half of the year and grew at a less than 2% annual rate, compared with a 5% pace in the first six months.